Wednesday, July 16, 2008

The dollar-crude arbitrage trade

Bernanke under oath testified before Congress that in his opinion the high price of oil is caused by supply and demand. The extend to which the value of the U.S. dollar influences the price of oil is highly complex and difficult to understand, so he sayed. Well Mr. Bernanke let me help you out. As the chart below shows the price of oil fell 10 percent in the last 48 hours in two separate five minute episodes. This resulted in a decline of the NYMEX CL August08 forward contract from peak ($146.73) to trough ($132.0) of $14.73. At the same time the EUR/USD cash contract declined from 1.6018 to 1.5897 between 10:00 and 11:20 a.m. on Tuesday and from 1.5890 to 1.5816 between 10:30 and 10:50 a.m. on Wednesday. As the chart below demonstrates a gain of 102 bp or 0.64% of the USD perfectly matched with the decline in the NYMEX CL August08 forward contract for crude oil.

The reason why crude oil future contracts plunged 10 percent are somewhat elusive but option expiration at the August 2008 contract on Thursday July 17 may have played a role. In addition the actual August future contract is about to expire on Tuesday July 22. The reasons for the concomitant decline in the U.S. dollar are less nebulous. It is simply the fact of an arbitrage trade or otherwise known as a "riskless profit" trade that is in play here. In other words being long crude oil and short the dollar is part of a speculation holiday for most trading desks on Wall Street. Mr. Bernanke if you and your colleagues could bring yourself to support the nations currency not only with lip service but with real action in form of a substantially higher fed funds rate, more inline with your real mandate, I predict oil prices would come down to $70 within a matter of weeks.

click to enlarge

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