Oil prices rally, pullback on horizon

Crude prices have surged more than 60% since March but fundamental supply and demand will keep a lid on how far they'll climb.

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By Madalina Iacob, contributing reporter

Click on the chart to see other commodity prices.
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NEW YORK (CNNMoney.com) -- Oil prices have vaulted above $78 a barrel this week as investors continue to fret about a weak dollar and the pace of the economic recovery.

Crude prices have gained more than 60% since March amid expectations that an economic recovery, especially in fast-growing emerging markets like China , would spur oil demand.

In search of recovery signs, the oil market often takes its cues from the stock market, seen as a barometer for the health of the economy. As the Dow Jones industrial average crossed the psychological level of 10,000 this week, oil prices followed suit, after months of vacillation in a tight range.

The renewed confidence in the stock market lifted investors' appetite for riskier higher-yielding assets, such as commodities and left the dollar, usually perceived as a "safe haven" in tough times, sinking. As the dollar decline, commodities become cheaper for holders of other currencies.

"The dollar is the linchpin to everything," said Zachary Oxman, managing director of TrendMax Futures. "If the dollar continues to weaken, the $100 a barrel level is around the corner."

The dollar index, which tracks the performance of the U.S. dollar against a basket of currencies, fell this week to its lowest point since August 2008. Near term the greenback is heading lower, but analysts expect a rebound by the beginning of next year. "There is this herd mentality, a maniac certainty that as the economy recovers the Fed will be unwilling or unable to restrain the forces of inflation and the dollar will be hard hit," Walter Zimmermann, United-ICAP chief technical analyst said.

However, consumers remain anchored and the immediate risk is still deflation, Zimmermann noted. "You need a microscope to find the recent uptick in consumer spending. There is a bubble to the commodity rally and the dollar and we are afraid that 2010 will be a replay of 2008 -- with an uptrend in the dollar, a downtrend in commodities, and further weakness in the real estate market."

The divergence between supply and demand forces in the oil market and concerns about the dollar weakness has left some market participants to call into question the recent uptrend.

The latest data from the Department of Energy show refineries cutting back drastically on their output, amid slack demand and ample inventories. According to Blake Fernandez, an integrated oil analyst at the New Orleans-based investment bank Howard Weil, all refineries except Tesoro Corp. (TSO, Fortune 500) will post a loss when the third-quarter results are released in the coming weeks.

"If you talk with refiners, they are not buying the oil and the refineries are the ones who need the oil," said Stephen Schork editor of energy newsletter The Schork Report. "It's a mania like the housing bubble. This is how bubbles occur. They detach from fundamentals and we are getting a participating rally not a fundamental rally."

The Organization of Petroleum Exporting Countries and the U.S. Energy Information Administration recently boosted their demand outlook for next year, as the global economy gradually recovers from the recession. However, when the economy does fully recover, demand for oil will have to be rampant to wash away the high OPEC spare capacity of more than 5.4 million barrels a day, analysts say.

"The market should be concerned that OPEC production has been rising for nine months and current levels of production are higher than projected demand for 2010," Tim Evans, analyst with Citi Futures Perspective in New York , said. "This is not a tight market ... it's speculation." To top of page

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