What’s Behind The U-Turn In Oil Prices

Only one short week ago I wrote that the price of oil is more likely to go down than up. It did drift down toward $122, but Thursday and Friday saw the largest price spikes in the history of oil, with the price ending at new highs. Why would I hazard a guess on the short term direction of oil after stating clearly that it is virtually impossible to make short term oil price predictions with any accuracy? That’s a question I will probably keep asking myself for a long time.

Here are the now painful words I wrote:

“At the start of 2008, I predicted that crude would trade in a range of $80 - $115 this year, later amended to $120. That was a boldly bullish expectation at the time, so the fact that my price target has already been surpassed by so much so soon is an indication of oil’s very unusual move so far this year. I’ve always said that in the short term, the price of oil can do anything and while that’s still true, my sense is that the nearly vertical rise in oil means that a pullback is overdue and therefore $135 is more likely than not to stand as a high water mark for a while. “A while” is a technical term meaning 6 - 18 months.”

Later in the post a few fundamental reasons why we might expect some short term weakness in oil were discussed. Do the last two days of higher prices mean all that was nonsense? Or does it perhaps mean that there are other forces that I did not consider which are driving oil higher despite the factors to which I pointed - the coming increase in Saudi capacity, the large amount of oil slated to come from many other new fields in 2008 and 2009, and the lagging effects of the past year’s higher oil prices on reducing global demand?

I may be a lenient critic of my own work, but I’m going to give myself an “incomplete” rather than an F in regard to this matter. To correct my error of omission, let’s look at what may be impelling oil prices higher so far this year and going forward, despite other forces that would tend to push it lower.

There are two very major global imbalances that impact the price of oil. One is the Rapid Transition that I’ve discussed at length, including in my last post. The other is the Arab-Israeli conflict. Both are obviously gigantic problems. In fact, they are so incredibly huge - and both so apparently intractable - that I may have seriously underestimated their possible impact on the price of oil in the short term, ignoring them like the proverbial elephant in the corner.

The Rapid Transition, as you probably know, is the long painful forced march that the world must endure from using hydrocarbons to using electricity for transportation and eventually for heating. It may be that the urgency to make this transition has simply not been communicated by pricing oil in the low $100’s. In fact the U.S. has particular urgency because of America’s enormous trade deficit which the high price of oil is exacerbating, a problem that becomes geometrically more urgent as the deficit builds on the impacts of past deficits. The trade deficit - now over $1B per day in oil alone - tends to weaken the value of the dollar which increases the value of oil in dollars, so it has become a feedback loop.

It may well be that the price of oil must go much higher much more quickly than we have assumed it would in order for global consumers and global political leaders to be spurred to start transitioning quickly. As some U.S. political leaders have begun to suggest, we need to embark on the transition to electric cars with the urgency of a “Manhattan Project.” Both Israel and Denmark have started down this road, but otherwise there seems to be little sense of urgency in the world. If you need evidence, look at the reaction of the G-8 just today. Yes oil is a problem, they say. Let’s have 20 “demonstration projects” by 2010. Piffle.

Maybe we need to be shocked by $200 oil or $300 oil in order to move quickly enough. After all we have been warned that oil supplies are likely to fall off a cliff sometime after 2013. That is only five years from now and it will cause unspeakable human catastrophe unless the transition is well underway by then. In fact, it may precipitate economic and political shocks on the order of the Great Depression even if we have begun a “Manhattan Project” to transition away from oil. If we have not done so it will be that much worse.

In sum, the coming shortage of oil supply relative to the trajectory of oil demand from growing economies and the related transfer of wealth from the western democracies to a few underdeveloped and undemocratic countries is an emergency of unprecedented proportions. The fact that our attitude toward this emergency seems to be one of mild annoyance and not full-throated rebellion against the old order may be why oil prices must go much higher.

A second and equally serious problem is the Middle Eastern conflict between Israel and some of its neighbors. Iran’s implacable march toward nuclear weapons and Israel’s equally unqualified refusal to see that happen shows no sign of a peaceful solution. The statement last week by an Israeli minister that the present circumstances seem to require that Israel take military action is only the logical conclusion of a continuation of present trends. Perhaps it will cause a change of course in Iran, but that seems like a long shot. Moreover, if the Israeli’s have in fact now given up hope that Iran will change and have therefore determined on a military solution, Israel will want to take its action some time before their certain ally, George W. Bush, leaves office.

If a military solution is undertaken by Israel, it is virtually certain that Iran will cause substantial disruption to the supply of oil from its part of the world. An increasing awareness by the market of that possibility would surely cause the price of oil to rise. If the risk were to become reality, the price of oil would probably spike very dramatically. Again, $200 or $300 oil would not be an unlikely outcome.

Possibly the world has been naive in underestimating the compulsion that Israel feels it is under to prevent Iran from achieving a nuclear arsenal, just as the world has under-estimated the urgency with which it must embark on the transition to electric transportation systems. Last week may have marked a wake-up call starting to be heard. The voice of the two crises is the price of oil.

Yes, last week’s price rise was spurred initially by the European Union’s hawkish stance toward fighting inflation, which caused the dollar to drop hard. A falling dollar raises the price of oil in dollars nearly by definition. But it seems to me that the strength of the move was far greater than would be caused simply by a new negative indicator for the dollar. Perhaps the twin catastrophes of an impending oil supply crisis and the escalating risks of an Iranian-Israeli war was part of it.

Finally, a comment on the stock market. I said in last month’s Newsletter # 15 that if the oil price falls for a while, stock prices should do well. By the same token, oil price spikes hurt stocks, for good reason. A New York Times front page report today discusses the rolling impact of higher oil prices on inflation in a wide range of consumer and industrial goods. Meanwhile, unemployment is clearly rising while home prices continue to fall. Taken all together, this looks a lot like stagflation, which is not a good environment for stocks. High oil prices, as the Times piece reports, makes inflation much worse and simultaneously acts as a tax on consumers, thus weakening the economy. So rising oil prices are a double whammy making them a significant negative for stock prices, while falling oil prices would help on both fronts and thus should help stocks.

I have long feared that sharply higher oil prices would kill stocks, including even energy stocks. We saw this happen on Friday. That’s why I developed a strategy of owning calls on long term oil futures as a hedge.

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