Oil Shocks

The United States financial system had a serious scare, the Europeans meandered through a dismal series of economic reports and oil closed almost $20 lower.  For all the cross currents this week it was the collapse in oil prices that holds the most promise for the American economy and the dollar.  The epicenter of this oil shock was not the Persian Gulf but Washington D.C. and in response the Dow Jones Industrial Average gained 3.6%, its strongest weekly rise in five years.

Political events gave oil traders and stock short sellers every reason to take profits. President Bush lifted the executive ban on offshore drilling on Monday and by Friday crude prices had completed their sharpest fall in percentage terms since late 2004.  Polls in the US show deep support for increasing the supply of domestic energy, drilling in offshore waters and Alaska.  But the Bush executive order was symbolic. It is a Congressional prohibition that blocks oil exploration offshore.

Oil traders are betting that this Congressional ban on drilling which covers 85% of US continental waters will not stand. The ban itself expires on September 30th and will have to be renewed by Congressional vote.  If Congress does nothing the ban lapses. Technically the ban is an annual Congressional prohibition on appropriations for the Interior Department for processing offshore drilling leases. Congress has renewed the moratorium every year since 1981.

The Democrats who control Congress have vociferously opposed letting US oil companies increase production from offshore supplies. Harry Reid the Democratic leader of the Senate and Nancy Pelosi the Democratic Speaker of the House both refused to consider modifying or lifting the ban. But this is an election year and offshore drilling in some capacity is very popular:  73% of the population approves modification or removal of the ban.  Will Congress bend to the popular will? Will Barack Obama change his anti-drilling stance as he seeks middle and working class votes, precisely those voters most affected by high gasoline prices and the voters he needs to get elected? 

Crude oil prices fell 11% on the week. Oil traders seem to have a clear opinion on the likely direction of Congressional policy.

Federal Reserve Chairman Ben Bernanke has maintained that slowing growth will eventually reduce inflation. The greatest source of inflation has been skyrocketing energy prices. Core inflation has risen only 0.2% since last June from 2.2% to 2.4%, while headline inflation has nearly doubled to 5.0% from 2.7%. If there were ever a justification for basing rate policy on core rather than headline inflation, it was this week's fall in oil prices.

But executive action in the US was not the only factor weighing on oil prices. The mild tone from the US and the Iranian governments concerning the renewed negotiations over the Iranian nuclear program also helped, as did an unexpected rise in oil stocks. And a world wide economic slowdown, though in many countries not reaching recessionary levels, is also cutting energy usage.

The combination of political and economic events was elementary reading for oil traders: take profits. But events could swiftly reverse the downward direction of oil prices. A military confrontation between Israel and Iran, more stringent sanctions on Iran for their nuclear program or any number of imagined or unimagined events could send oil back to its recent highs and beyond. If crude oil returns to its heights then traders will punish the dollar and this time the euro will probably not stop at 1.6040. The return of a nightmare is often scarier than the original manifestation. So it will be if oil returns to $145.

The US economy has three main problems, commodities prices, (read oil), the housing market collapse, and the fear generated by financial failures. The housing decline, while translating into an enormous problem for the financial sector, has had a muted effect on the economy as a whole and on consumer spending. The financial fear is serious and as more institutions fall under suspicion it damages stocks but in reality it has, as yet, had minimal effect on the consumer except in its effect on consumer sentiment.   

Despite all these interlocking problems the US economy has not derailed. But it is directly affected by oil and gasoline prices. The Fed has provided 325 points of rate reductions in less than a year. The Federal government has delivered a large economic stimulus. The question now is have these moves prevented the bottom from falling out of the US economy or are their simulative effects simply taking more time than usual to promote a recovery? And despite all the recent criticism directed at Ben Bernanke for the weakness of the dollar it is that dollar which has spurred US exports providing a large measure of support for American productive firms.

In July 2007 premium gas averaged $3.15 a gallon in the United States; at the beginning of 2007 it had been $2.50. Premium fuel is now $4.30 a gallon. Where would the US economy be without higher gasoline prices?   Of course higher gasoline prices and lower economic activity are not a simple trade off. One of the factors driving oil higher was the falling US dollar. The dollar weakened because of Fed rate policy, itself predicated on the housing and credit problems in the US. But the rise in oil prices and thus gasoline has far outstripped the fall in the dollar. And so the punishment inflicted on the US economy by energy prices was far greater than the reflection of the dollar decline.

The betting this week was that if the excess in oil expense is removed then the Fed rate reductions will have a better chance of returning the US economy to prosperity. That was the defensive view in the stock market. It may soon become the opinion in the currency markets as well.

Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst

Joe@fxsol.com