Stormy Weather For Crude Prices

Jim Brown
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Conditions are worsening for crude demand and for crude prices as news from around the world suggested there was trouble ahead. The news of the Saudi production cut of 800,000 barrels and claims by the IEA that current prices could push the world back into recession caused prices to fall sharply.

I wrote about the 800,000 production cut by Saudi Arabia over the weekend so I won't delve into again here but to say they could not sell their extra production due to lack of demand for sour crude. If supply conditions were dire there are some refineries that would take it but obviously there is no critical shortage at this time.

The IEA warned at a meeting in Kuwait that oil prices at the current level could trigger a recession similar to the one in 2008. There are quite a few analysts that believe oil prices were the main driver in 2008 and rising energy costs created conditions where subprime borrowers could not fill their tanks and pay the mortgages at the same time. The rising defaults in mortgages then triggered the wave of panic that tanked the banking system. Whether high oil prices were the trigger or just a contributing factor remains to be seen BUT historically we have seen that high oil prices almost always lead to a recession.

I am worried that the current state of the U.S. economy with expected Q2 GDP well under 2% is too weak to survive a sustained bout of high oil prices. There will be significant demand destruction at the current level and there will be significant cuts in consumer spending and a decline in economic activity.

On Monday we also received a shock from S&P when they downgraded the U.S. debt outlook to negative from stable. That means there is a 33% chance of a downgrade in the AAA rating over the next 2-3 years. The market took it hard and the Dow was down -247 points at the open.

A loss of the AAA rating would mean trillions in treasuries would have to be sold because thousands of fund managers, retirement funds and institutions are prohibited from owning any debt instrument that is not rated AAA. If this happens interest rates would quickly double and then begin a long move higher. The U.S. would have to sell even more debt to finance the rise in interest payments. It is a vicious cycle that could take years to play out but would likely lead to hyper inflation and a serious economic decline.

The downgrade should not have been unexpected. The press has been harping on the debt issue for the last couple years but lawmakers have only recently begun to pay attention. Avoiding a debt downgrade will require major cuts far above those currently being discussed. They will have to be real cuts and not fantasy cuts like canceling $5 billion in unspent TARP funds and calling it a spending cut like they did last week.

All of these factors are pointing to an economic decline in the U.S. as austerity measures of various types are put in place. It will occur over years not months but like Greece there will be pain for the working class. Companies could return to conservation mode and end the current increase in hiring. They may put off expansions and building programs until they see if a real change is coming.

The U.S. outlook downgrade is a problem that is not going away. The market may recover in the short term but with the FOMC likely to announce policy changes soon and now the debt cloud the level of uncertainty is only going to grow.

This is not an environment where oil demand increases. This is an environment where demand decreases and that means the outlook for crude prices is negative. The drop back to $107 today could be just a starting point. The WTI futures expire at the close on Tuesday so I would not be surprised to see another drop tomorrow.

On the flip side the Saudi production cut could actually support prices since it would appear OPEC is determined to not push prices lower. They seem to be happy with $110-$120 oil if they are willing to cut production to keep it there.

The next few weeks should be interesting in the oil market and the equity market. We could be looking at an entirely different market three months from now.

Jim Brown

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