Oil Prices

The uncertainty in the global credit markets, coupled with the clear realization that the U.S. housing market is set for a multi-year decline, will cause a deterioration in demand starting with the U.S. consumer that will be felt worldwide. This slowdown in demand will ultimately affect world demand for energy in all forms..

Energy continues to be the major story in the financial markets. Oil prices, which have just topped $125/barrel for the first time ever, have nearly doubled over the past year. The price of oil is clearly very stretched on a short-term basis. Oil is trading 35% above its 200-day moving average, which matches the largest upside deviation from its longer-term uptrend line since oil’s bull market began six years ago. Undoubtedly, a correction is looming (perhaps back to the $90-100 level?), but those looking for a major, sustained drop in the price of oil are likely to be disappointed. In inflation-adjusted terms, oil is now trading at the peak levels registered in the 1970s, so oil is unlikely to continue to soar from current price levels (absent the outbreak of war in the Middle East). However, we would not be looking for a major decline in energy prices, given inexorable demographic-driven demand trends and the inflationary monetary forces supporting commodity prices.

A consumer survey done pointed to a bearish scenario -- with two-in three consumers (67%) saying their discretionary spending will be lower for the next 90-days because of increased energy costs. The number of respondents cutting discretionary spending catapults to 87% among households earning less than $50,000 per year.

More countries are reducing subsidies of crude oil prices. This will soon lead to a decreased demand from parts of the world where consumers have been shielded from the higher prices. Many of these countries have huge populations (e.g. India, Indonesia etc.). Moreover, legislations have been passed to limit commodity swaps that bypass commodity futures contract limits.

The expansion in the prices of commodities priced in U.S. Dollars has been as much a function of expanding global credit as it has been one of fundamental demand. Thus, the reduction in available credit to world markets (dollars) will cut into world demand for such commodities.

Raising the margin requirements. It is easy to make the case that the margin requirement for the crude oil futures contract has simply not kept up with the price increases. Each crude oil contract represents 1,000 barrels. At around $132/barrel, one contract is worth $132,000. But the maintenance margin is only $7,250. That’s over 17 to 1 leverage. The commodity exchanges are sensitive to pressure from Congress, and will most likely raise the margin requirements in the near future. This could have a dramatic downward effect on prices. (Remember silver and the Hunt Brothers in 1980.)

Swedish oil company Lundin Petroleum announced it has made a major oil discovery in Russia's north Caspian Sea. The discovery was made during exploratory drilling on the Morskaya-1 well on the Lagansky block, which has estimated reserves of more than 800 million barrels of oil. "This is a world class oil discovery which has confirmed the excellent prospectivity of the Lagansky block," said Ashley Heppenstall, President and CEO of Lundin Petroleum. More Oil supplies is likely to bring the price of oil further down.

This seems like a good strategy: Swedish company make a major discovery of oil in July, and it plans to start drilling in just TWO MONTHS. Compare that to the U.S. strategy - discover major deposits of crude oil in ANWR in 1987, and ban drilling for more than TWO DECADES.

The expansion in global credit has fueled the recent surge in global demand for all asset classes as much as (or perhaps more than) any other fundamental driver of demand. Furthermore, the US dollar has been weak because of the previous interest rate cuts. But the cuts seem all but over now. The rest of the world will soon need to cut interest rates to catch up with the US. This will lead to a stronger US dollar and weaker crude oil prices in dollar terms.

-- I'm not sure who edited this, but as the original contributor of the very FIRST line (expansion of global credit), I'm surprised the last editor got it so wrong. Interest rate cuts DO NOT push the value of the dollar higher. They push the value of the dollar lower, unequivocally, as you are creating MORE dollars (why do you think that they lower rates? To encourage borrowing, which itself increases the supply of dollars). As oil is priced in dollars, but is a global commodity, if you supply more dollars to the world vs. foreign currencies (US Dollar devaluation) while holding constant demand you get - voila - an increase in the price of oil priced in US Dollars. Simple.

On the other hand, what we will find going forward is that the cost of credit will become more expensive as counterparty risk becomes paramount to fueling global growth. Interest rates will necessarily go higher as counterparties demand higher compensation for their risk taking activities. This will cause a contraction in the supply of dollars (Central banks sell bonds to investors in exchange for their dollars, the value of those bonds decreases and interest rates rise vis-a-vis). A contraction in the supply of dollars means less dollars available to purchase commodities, which in turn perpetuates a decrease in the price of said commodities.