Debt Worries Pressure Crude

Jim Brown
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The lack of an agreement in Washington on the U.S. debt limit and another downgrade of Greece was more than the equity markets could bear on Monday. Just when Greece was supposed to be moving out of the headlines Moody's downgraded Greek debt three more notches to "Ca" from the already junk status of "Caa1." If U.S. lawmakers don't end the current political theater in Washington we may be on the road to junk status as well.

The Greek rating of Ca is just one class above default. Moody's took this action because the support package that requires the participation of private investors means those investors are "almost certain to incur credit losses" according to Moody's. If the debt exchanges occur as suggested Moody's would define this as a default by Greece on its public debt.

That should come as no surprise. The 21% haircut envisioned in the new bailout package for "voluntarily" swapping old debt for new and longer dated new debt, is probably generous according to most analysts. Almost everyone believes Greece will also be unable to pay its new debt so it is only a matter of time before a new haircut is required which could be as much as 75%. Analysts claim Greece, even with its new long-term bailouts, cannot over the next decade generate enough revenue to pay the debt service on its growing pile of debt. There will be a complete breakdown in payments by Greece but the new structure kicks the can so far down the road everyone in the Eurozone will have time to write down the debt so when the major default occurs it will not be terminal for the European banking system.

Unfortunately analysts believe the Greek bailout has not set a precedent for future bailouts on Ireland, Italy, Portugal and Spain and that will be even worse because the ECB will not be able to raise enough money to stay afloat. This will eventually drag the European banking system down and cause a breakup of the EU according to many analysts. Because the future appears so clear for future PIIGS defaults the new bailout for Greece and future nations that was seen as a rescue plan last week is starting to look like an anchor that will eventually lead to the downfall of the EU. If not a downfall at lease a long term recession because of the multiple countries implementing austerity and falling back into a recession. Recession and austerity means slowing of oil demand.

The rebounding worries over Europe were just one factor weighing on oil prices today. The debt limit theater in Washington is also weighing on prices. The war of words in what has become an early battle over votes in the 2012 elections has depressed consumer sentiment and reduced significantly reduced market volume.

Volume across all exchanges has been only 5.8 billion shares for the last two days. This is 30% below the 60-day average and well below normal volumes for summer trading. Retail traders and investors don't know what to do. Institutions, which are supposedly smarter and more agile are also confused. Hedgefunds took major losses in Q2 in the 6% to 12% range because of the volatility and indecision. Many hedge funds have gone to cash with levels as high we 75% in order to wait out the conclusion of the debt limit scenario.

While this is creating significant pent up demand once the problem is solved it is adding to the cloud over the markets. With funds sitting on the sidelines it creates a lack of volume and that increases volatility and the situation is self-propagating.

The President, Senate and the House appear to be pursuing a path of mutual assured destruction. By politicizing every point in daily press conferences they are firing artillery salvos towards voters that are alienating even the voters on their own sides.

The democrats can't run the 2012 elections on the current economy so the only hope they have is to scare the voters with claims of missing social security checks, no funding for schools, Medicare cuts and higher costs. The republicans are trying to pin the economy on the democrats, blame them for higher taxes and lower employment.

There is no reason for the current crisis. The debt ceiling has been raised 74 times since 1960. It was raised eight times during the Bush years and three times while President Obama has been president. This is strictly a political war not an immediate problem for the U.S. economy. Eventually debt will be a major problem and will have to be dealt with it is not a specific problem today.

There is no threat of a U.S. default. This is a scare tactic promoted by politicians. The government takes in over $200 billion in revenue a month and debt payments on Treasury securities is less than $30 billion a month. Both parties know they can pass a bill hiking the debt limit in 48 hours or less. What they don't seem to realize is they are risking a ratings downgrade with their brinksmanship.

The markets have now shifted from being concerned about a technical default on the debt limit to being concerned about the long-term impact of a ratings downgrade. The market has seen multiple warnings from S&P and Moody's about the potential for a ratings cut EVEN if the debt limit is raised. The key for the ratings agencies is not really the debt limit but how the spending cuts are going to be made when that limit is finally raised.

The ratings cut is the biggest problem facing Washington and the markets. If our credit rating is cut because Washington continues spending as usual with no material cuts, the damage to our economy will be enormous. The $14.3 trillion debt, soon to be nearly $17 trillion when the limit is finally raised is more money than the U.S. can pay off in our lifetimes.

Attempting to lower the annual deficit, currently $1.3 trillion a year, will be tough enough but then to tackle the $17 trillion debt on top of that will be nearly impossible. It will require drastic spending cuts by government plus higher taxes on businesses and individuals. Both of those measures will reduce economic growth significantly and will likely put us back into a recession that could last the rest of the decade once it begins.

There are between 15-17 million people out of work today depending on which number you use. Some claim it is over 20 million. Even using the lowest number the continuing damage to our economy is enormous. There are 44 million people on food stamps in the USA. People on food stamps are not consuming, sending kids to college or starting new businesses. There are millions more on welfare, unemployment and medical assistance. The debt limit is a side show with a serious ramification to our credit rating but the debt is the cancer that will kill us or at least slow the economy to the point where there will be no pulse.

In the economic future oil prices will rise not because of increased demand in the U.S. because all those problems above will prevent a strong recovery. Prices will rise because demand outside of the U.S. and Europe is rapidly expanding and production is not.

As those prices rise the impact to an already crippled U.S. economy, undergoing austerity in an effort to reduce debt, will be a deadly poison. We should see oil prices over $125 in 2012 and over $150 in 2013 and the sky is the limit in 2014 unless those high prices have already pushed the world economy back into recession. We saw what happened in Q2 when WTI prices hit $115 and Brent $125 and that was just a one month spike. Gasoline was over $4 in 23 states and the U.S. consumer went immediately back into conservation mode. Prices have fallen back to $3.69 nationally but demand remains lackluster and oil prices are rising again.

The artificial debt limit crisis may be getting all the headlines but there is a bigger problem. Crude oil is $100 today despite our lack of demand. Washington can't legislate away oil prices and they refuse to even acknowledge there is a problem. The debt limit is a pimple on the U.S. economy but rising oil prices is a slow growing cancer that cannot be eradicated. Combine the soon to be $17 trillion in debt and rising oil prices and our long-term economic future is bleak.

Washington, pop the pimple and get on with business! Open up the offshore permit process and all offshore areas for drilling. Analysts believe a full blown exploration and drilling program could employ 230,000 workers and generate up to $400 billion a year in lease sales, royalty revenue, income taxes on companies and workers and the increased profits from all the businesses supported by the oil industry. Why, with all the worry over a lack of revenue in Washington do they continue to ignore the golden goose of the energy industry? No other industry in the U.S. can produce the amount of direct revenue for the government as the energy industry if the government got out of the way. Instead of fighting over reducing the $10 billion or so in tax incentives to oil companies they should be helping them overcome obstacles to exploration and new production. The best way to offset high fuel prices in the coming years is to boost production in the U.S. by a couple million barrels per day and it is entirely possible.

Quit sniping at the other political party and get on with the business of preventing an economic meltdown.

Jim Brown

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