Saturday, July 9, 2011

Oil Market Surprise

There was a real shocker in the oil markets recently, sending prices tumbling.....

Western nations, through the International Energy Agency, announced the impending release of the largest amount of oil from their emergency strategic reserves since 1991.

Over the next few weeks, the IEA will release 60 million barrels of light, sweet crude oil. The release is to be led by the United States which will provide 30 million barrels of oil to the market.

The stated reason behind the release of oil from inventories is to replace the loss of production from Libya.

But the real reason behind the move is a rather different one and shifted the landscape in the oil market permanently.

Weak Global Economy and Politics

In the past, the IEA released oil from its reserves only when a major supply disruption occurred such as the Iraq War and Hurricane Katrina.

But now this release is happening when the only disruption to oil supplies is the minor one in Libya where production has fallen from 1.6 million barrels a day to just 200,000 barrels.

This is where it gets tricky for investors. The IEA decision was one based not on supply/demand or economics, but on politics.

It was a move aimed directly at putting a ceiling on oil prices. It is also intended to, in conjunction with increased Saudi production, bring down the price of oil quickly and sharply.

The reason is obvious. Western economies, particularly the United States, are slowing down rapidly. These economies are struggling with stubbornly high unemployment and consumers hurting from high prices for commodities like fuel. It is a very real effect. Goldman Sachs estimated that the rise in oil prices took $118 billion out of the US economy in the first quarter alone.

A sharp drop in the price of oil will serve as a stimulus to the global economy. This includes the United States where the effects of previous fiscal and monetary stimulus have worn off. The Federal Reserve two weeks ago issued a downbeat outlook for the US economy, emphasizing that growth would be lower than previously expected in 2012.

The US economy looks to be desperately in need of a stimulus heading into 2012 – an election year. Especially since it seems the Federal Reserve will hold off launching QE3 for at least a few months.

And so what do we get? Voila – we get stimulus – a release from the emergency oil reserves when there is no emergency, only an upcoming election.

The stimulus should work too, at least for now. Estimates are that for every $10 rise or fall in crude oil prices, there is a move of about 0.5 percent in the nation's gross domestic product.

Politics entering the equation may have permanently changed the way the IEA works. The IEA, largely controlled by Washington, will apparently intervene much more often now and enter the market with sales from its reserves any time the price of oil is deemed to be “too high”.

Who Benefits

For certain, the change in how the IEA works will put a ceiling on oil prices over the short and medium term.

Who stands to benefit from lower oil prices? Obviously, every consumer of oil on the planet including the United States.

But the ones benefiting the most will be the emerging markets. Consumers in these countries pay a much larger portion of their incomes than Americans do for basic commodities such as food and fuel.

Even the IEA stated that demand for oil is strongest in the emerging world and that countries including China, India and Saudi Arabia are the ones where demand for oil is growing the quickest.

Emerging markets are currently suffering because their central banks are raising interest rates due to rising inflation. Much of that inflation stems directly from soaring prices for commodities like oil.

So a drop in oil prices will likely begin a process where interest rates in the emerging world begin falling again, adding stimulus to already fast-growing economies.

Therefore, the current weakness in emerging market stocks presents a buying opportunity for investors.

But keep in mind that this form of stimulus cannot last for long. If the IEA keeps releasing reserves to lower oil prices, its inventories will eventually become depleted.

And as the IEA tries to restock its oil supplies, adding more demand, that will lead to much higher oil prices in the long term than otherwise would have been expected.