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Weakening of US Dollar against a basket of G10 and EM currencies contribute to higher energy prices in US Dollars. Low elasticity of both demand and supply in the petroleum markets and constant recycling of petro dollars into Euro kept oil prices and trade-weighted US Dollars trading in synbc, pushing oil prices above $80 per barrel several times, according to an analysis by Bank of America Merrill Lynch (BofAML).

The analysis pointed out that weak US Dollar will lead to gold appreciating against all currencies as emerging market (EM) Central Banks increase their allocations to gold and push prices above $1500 per ounce, oil prices will follw the trend. Thus it may not come as a surprise if WTI crude rises to $100 per barrel by late 2010 or early 2011.

Global economic recovery could lead to tighter physical oil supply thus WTI crude could average $85/bbl in 2010. The synchronous resumption of idle industrial capacity and trade around the world should support a big up-tick in demand for middle distillates, BofAML analysis said. It has raised its 2010 average forecasts for heating oil and gas oil crack spreads to $10.60/bbl and $13/bbl respectively. Record storage levels have brought down natural gas price at the Henry Hub and BofAML sticks to its forecast of $6/MMBtu relative to a forward of $5.40/MMBtu. By fourth quarter of 2010, US nat gas prices will rise to $7.60/MMBtu, 27% above the forward.

The link between FX and oil could be breaking down
With the US economy in need of a weak currency to address large trade and government deficits, a weak dollar is undoubtedly helping. But the weak dollar has sent USD-denominated commodity prices higher. In recent years, the commodity and FX markets worked under the assumption that a weaker USD is synonymous with higher gold and oil prices. However, India’s recent large offexchange purchase of gold was enough to send exchange-traded gold prices
higher despite a stronger trade-weighted USD on the day. India purchased 200 tons of gold from the IMF at an average of $1045/oz for a total value of $6.7bn.

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BofAML analysis said that this change could signal the realization that “beggarthy-neighbour” policies to get out of recession have natural limits. Dollar weakness may start to recede and, in turn, a string of competitive currency depreciations among G10 currencies may be the new game in town over the coming months.

There is a risk of waves of competitive G10 FX depreciation
If the US prints money to fight off deflation, Europe has to follow or suffer from a USD competitive depreciation.However, few G10 nations are willing to embrace further currency appreciationagainst the USD. This creates a vicious cycle, where a USD competitive depreciation leads to a GBP competitive depreciation, which in turn leads to a Euro competitive depreciation and so on. Because the public finances of the US, Japan, Britain and the Eurozone are in such dire straits , it is hard to
envision how these countries will return to trend economic growth without robust foreign demand, suggesting that this dynamic could go on for a while, BofAML analysis pointed out.

Gold will likely lead other commodities higher
Emerging market Central Banks can only hedge against this competitive depreciation dynamic by buying gold. As gold prices go up, the idea that G10 fiat currencies are being debased takes hold, pushing up other commodities like oil. This shift in market leadership is consistent with the long-term perspective on the relationship between oil and gold, and it is also consistent with a weakening Euro in the months ahead. BofAML analysis indicates precisely this trend, with inflation,
currency and commodity markets showing a direct or indirect link to gold.Meanwhile, none of these markets seems to be leading gold, suggesting the yellow metal is on a trip of its own.

How to reconcile rising gold & oil prices with a weaker Euro?
Put differently, the Euro is too strong against the USD, but cyclical and reserve diversification pressures should keep oil and gold prices on an upward trajectory. There are two channels that reconcile a weaker EUR with rising gold and oil prices. First, more flexibility in EM currencies (a Chinese Yuan revaluation) will ultimately reduce reserve accumulation and flow diversification demand for EUR out of USD. At the same time, stronger EM foreign exchange reserves will effectively boost EM commodity purchasing power. In turn, EM FX appreciation reflects the strength of EM vs.developed economies and is linked to an improving commodity outlook.

Second, greater EM central bank preference for physical assets over fiat currencies in FX reserves can reconcile higher oil and gold prices with a weaker Euro . The shift could reduce the flow diversification demand for Euro out of USD, and push this money into gold instead. It is no secret that the supply of fiat currencies like the EUR is growing at a much faster pace than gold holdings. The ultimate problem here is one of excessive reserve, accumulation which can only be solved through EM FX appreciation. Thus, if EM governments choose to keep their currencies artificially weak versus the USD, the rising gold price will drag commodity prices up with it, hurting EM consumers. To avoid this problem, EM central banks will have to allow for faster FX appreciation. This dynamic will ultimately make room for a greater level of EM consumer commodity demand, supporting stronger USD-denominated commodity prices, BofAML analysis said.

$100+/bbl oil, $1500/oz and 1.28 Euro-USD targets intact
The signal sent by the Reserve Bank of India and the market reaction that followed suggests that it is possible to reconcile a weaker Euro view with rising oil and gold prices. As a result, we want to emphasize again our view that WTI crude oil prices could break through $100/bbl as we approach 2011 on the back of monetary and cyclical pressures, our view that gold will break through $1500/oz within the next 18 months and our view that the EURUSD will trade at 1.28 by end-2010. The market could, of course, move a lot faster as EM Central Banks rush into gold sooner rather than later. But more critically, whether this change in correlations breaks the relationship between the Euro, commodities and risk appetite could well depend on the speed of the adjustment.