The following special report on oil (LA Blog Only, leverageacademy.com/blog) discusses the oil market, providing reasons to be bullish on the commodity given unrest in the Middle East, Nigerian elections in April, and rising domestic consumption in oil producing countries, including Venezuela, Nigeria, and Iran. According to the article, the rise of oil prices could easily cause the next recession. In 2010, soft commodities outperformed energy, but that will certainly change given the political headwinds abroad and continued monetary easing in the developed world. Therefore, the Bernanke “Put,” combined with political unrest will be to blame for continued sharp price increases in the energy commodity sector.
Emerging market demand, especially in China, which now consumes nearly 10mm barrels of oil per day, will also be driving the demand side of the equation. Money supply in China was also up 19.7% in 2010, because of the rapid credit growth the country has experienced over the past 2 years.
On the supply side, Middle Eastern youth continue to riot, causing political unrest across the globe. In Egypt, Libya, Morocco, Saudi Arabia, Tunisia, and Bahrain, youth unemployment is over 20%, which is a severe concern, given the oil wealth of these nations. The Iran crisis could also re-emerge as the country continues to develop nuclear weapons. As Iran is mostly Shiite, it poses a great threat to its Sunni neighbours, including Saudi Arabia. Major risks in the area include that the Straights of Hormuz and Malacca could be blocked in the Middle East if major riots break out. These two passages account for 32 million barrels of crude transport per day. The Straight of Hormuz alone carries 33% of oil transport by sea. Furthermore, one should question how much Saudi Arabia can increase supply, as the country overstated its oil reserves by nearly 300 billion gallons in 2010. Even if it does increase supply, how will this supply be transported to the West if passages are blocked?
There has not been one year in recent history where Nigerian elections have not posed a threat to the country’s oil supply. Elections are often bloody, and there is no reason for the upcoming 2011 elections being held in April to be different.
To make things worse, the IEA increased its oil demand forecast by 1.6%.
On December 6th, Brent futures were traded in backwardation for the first time in two years, which means that futures with shorter maturities are more expensive than those with longer maturities (similar to an inverse yield curve). Backwardation occurs in tight markets, whereas contango occurs when there is oversupply.
What will be the effect of these changes in the oil supply/demand equation? Well, an increase in oil price tends to affect the economy with a time lag of at least 4-6 months. An increase an oil price of $10 would cause GDP to fall by 25 bps and S&P earnings to fall by $3.00.
According to the IEA, 4.1% of GDP was spent on oil consumption in 2010. A sustained price above $100 would mean that the percentage would increase to 5%. Oil at $120 would mean a percentage increase to 6%, which would be devastating.
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