THE ENERGY REVOLUTION INTENSIFIES
by Dan Denning
This latest rise in energy prices will have at least three distinct impacts. First, the stock market will see new leadership from the oil and energy sector. Oil and energy indexes and ETFs will gain in popularity with institutional
and retail investors alike.
Second, rising oil prices are going to have knock-on
effects in the world's currency markets. Oil, of course, is
priced in dollars. And as it rises, governments around the world will have to decide how to handle the double whammy of rising oil prices and a falling dollar.
Already, governments in Russia, Japan, and South Korea have
decided to "diversify" by owning fewer dollars and more
euros. You'll see more dollar diversification as
governments hedge their dollars (and rising oil price
risk). This will also have an effect on U.S. interest
rates.
Third, rising energy prices are going to intensify the
great game of geopolitical chess that's unfolding before
our eyes. There are many players in the game, but the key
ones are Iran, Russia, China, and the United States.
Wall Street does not believe in $40 oil. But prices
shouldn't have anything to do with belief. There is a deep institutional skepticism that oil is now priced "petro-politically," or that the political premium in oil means the base price for crude is now $40, not $25-30.
Saudi oil minister Ali Naimi - at the mid-March OPEC
meeting in Tehran - said the Kingdom thinks oil should
trade between $40-$50 per barrel, in order to ensure steady
global growth. He also said he thinks that oil at $55 per barrel is "too high."
There are lots of people on Wall Street who agree with him.
You wonder if these oil skeptics have a basic grasp of
supply and demand. First of all, in real terms, oil is
still trading well below what it was during the oil shocks
of 1970s.
Oil is still cheap! It would have to rise to $80 in today's
dollars to reach its past highs. In other words, the big
bull move in oil - even after a doubling in crude futures
in the last year - may not have even started yet.
And why is that the case? Supply and demand. In its
constant quest to turn news into an explanation for price movements, Wall Street pays religious attention to the forecasts of the International Energy Agency and the inventory figures produced by the American Petroleum Institute. But seasonal or monthly fluctuations in oil inventories or demand don't begin to give you the fundamental picture.
The fundamental picture is very simple, almost childishly
so. Demand is increasing; supply is not. That's it. No
hidden logic. No secret turn of events. More people are competing for the same scarce energy than ever before. If anyone tries to tell you that oil ought to be at $25 and that this is a bubble top, ask them what recent forecast showed an increase in the world's oil supply. Don't be surprised if they look at you like you have three eyes. No such forecast exists.
There are other factors affecting the oil price. The dollar
is one. But a long-term increase in demand is the biggest
one. The demand for oil is leading commodities to take over
as the asset class of choice for the world's investors.
Since stock markets peaked in 2000, the Dow Jones AIG
Commodity Index has absolutely outperformed the S&P 500.
The Dow remains the most difficult of the three to
forecast. Economically, high oil runs the risk of slowing economic growth and damaging corporate earnings, which is generally bearish for stocks. Obviously, the entire energy complex (shippers, refiners, explorers, major integrated
stocks) is the exception to the rule.
There is also the possibility (or even likelihood) that
oil's climb to 1970s levels will be a stair-stepping
process, ascending in big gaps and pausing to collect
itself. This gives the Dow and other major indexes a chance
to "price in" the move. Big daily changes in the Dow are
less likely in this scenario.
But we can't really forecast the Dow without factoring in volatility. Volatility - as measured by the VIX - has been so low for so long that nearly everyone expects it to increase soon. It's one of the market's strange ironies that low readings on the VIX do not actually mean the market is stable, but that pressure is building for a big move. But which way? Will increased volatility on the VIX be bullish or bearish for the Dow?
The answer is "bearish," but for traders, the Dow isn't the
index to watch when the VIX rises. Individual Dow
components will react differently to a rising VIX. But in general, rising volatility means a decline in speculation.
What about bonds? If the early price action is any
indication, high oil is bullish for bonds. In my speech at Investment University in Delray Beach, Fla., I said that higher oil prices would force investors to choose between emerging markets and U.S. bonds. Up till now, investors have had the leisure of chasing higher yields in emerging markets without the worry that oil prices would hit less-developed economies hard. Not anymore.
The net effect - again based on the early trading patterns
- is that investors are selling emerging markets and buying
(gulp!) U.S. Treasury bonds. This is the classic "flight to
safety" move we've seen in the past. Selling emerging
markets because of rising oil prices makes sense to me.
Buying U.S. bonds as a measure of safety does not.
As one reader pointed out to me at Delray Beach, however,
good investors do not confuse what should happen with what
is happening. You can outsmart yourself by coming up with
too many reasons why investors should not buy U.S. bonds.
And just for grins, I can think of three of them right off
the top of my head: $59 billion, $113 billion, and $666 billion.
Fifty-nine billion dollars was the February trade deficit. Americans continue to consume more than they produce. The last I checked, this was still NOT a way to get rich. The next number, $113 billion, was the federal government's February deficit. The Great Fiscal Father in Washington continues to set a bad example to a nation of fiscal children by spending more than he takes in. This, too, should be bond bearish. Yet it isn't.
Finally, the diabolical last number, $666 billion. That was
America's current account deficit for 2004. It was a 24% increase from the year before. It now amounts to 5.7% of GDP. But those are just numbers.
Let me put it in plain terms for you: America is
increasingly dependent on foreign central banks to sustain
the value of the dollar. High consumption is made possible courtesy of the world's savers. We are getting a free ride into indebted servitude to foreign bondholders. The ride into indebtedness may be free, but getting out is going to be very expensive.
That trifecta of debt ought to be enough to scare the
daylights out of U.S. Treasury bondholders. But in the
context of high oil prices, the debt numbers take second
place in investors' minds - at least for now. U.S. bonds
are getting a bid.
Fundamentally, the stage is set for a huge dollar sell-off.
With the deficits soaring, demand for the dollar is bound
to wane. When it does, the dollar will go down, interest
rates will go up, and a whole series of secondary reactions
will unfold in the markets.
Regards,
Dan Denning
for The Daily Reckoning
Editor's Note: Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 - where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends. |
