Oil Price Breakout, Signaling Commodities Uptrend

Oil prices jumped to near US$86 a barrel Monday in Asia, extending gains from last week as investors bet an improving US job market will herald growing crude demand.

Benchmark crude for May delivery was up 80 US cents to US$85.67 a barrel at midday Singapore time in electronic trading on the New York Mercantile Exchange. The contract climbed up US$1.11 to settle at US$84.87 on Thursday following a gain of US$1.39 on Wednesday. Global oil trading was closed for the Good Friday holiday.

Oil broke out of its multi-month trading range today. Oil bulls are hoping this is the start of another run higher, while most consumers are probably thinking "not again."

Crude has jumped from US$69 a barrel in early February on expectations a growing US economy will eventually spark higher oil consumption.

On Friday, the US Labour Department said employers added 162,000 jobs in March, the largest job gain in three years. The unemployment rate stayed at 9.7 per cent for the third straight month.

'The market was positive before but now it's been confirmed,' said Clarence Chu, a trader with market maker Hudson Capital Energy in Singapore. 'If the job growth can be sustained for several months, we'll definitely see crude demand pick up.'

In other Nymex trading in May contracts, heating oil rose 2.09 US cents to US$2.2376 a gallon, and gasoline gained 2.10 US cent to US$2.3442 a gallon. Natural gas jumped 1.5 US cents to US$4.101 per 1,000 cubic feet. In London, Brent crude was up 71 US cents at US$84.72 on the ICE futures exchange.

Oil is the leader for all commodities, the following weeks should see the other commodities, including soft commodities, finding reasons to surge alongside oil.

Lessons From The Current Oil Shock

I came across one of the smartest article in Newsweek (31/10/05) written by Ruchir Sharma (co-head of global emerging markets for Morgan Stanley Investment Management) on the present oil shock. Many are confounded by the lack of calamity owing to the recent surge in oil prices. Sharma cited some clever insights and I would like to add to them:

a) The present oil price bull market is due to demand-surge factors and supply growth that could not cope. This is very different from previous oil price rallies which were more likely due to supply shocks (e.g. wars, embargos, cartel behaviour). What this means is that a very strong global economy is pushing demand for oil, and the usage of oil is more for production of goods which has an end market demand. Hence oil consumption is largely for "productive means". The higher cost of oil is more easily absorbed or passed on along the production and consumption processes.

b) It used to be that higher oil prices meant that we are lining the pockets of OPEC nations at the expense of non-OPEC nations. Back in the mid 70s, the additional revenue from jumps in oil prices stayed mainly with OPEC nations and was not recirculated back to the global economy. Sharma cited UBS economic research as saying that back in 1974 only 27% of petrodollars was recycled back into the global economy. Now OPEC nations are more involved with the global economy by consuming as much as 83% of oil revenues. An example would be the aggressive purchasing of US Treasuries by OPEC nations which lowers the global cost of capital, thus allowing the major economies to chug along without higher interest rates cutting off economic activity.

c) The present oil shock has also magnified countries that have been subsidising the cost of oil in their country (namely Malaysia, Indonesia). These oil price surges have reinforced the growing amount of subsidy, which could have been better spent to revitalise other areas of their economies. Malaysia, correctly surmised that they should reduce the level of subsidy. In fact, one can safely say that countries engaging in subsidising oil prices are gradually lowering their subsidy from here on. It is not prudent to artificially sustain a country's competitiveness and purchasing power via the subsidy method. The political will to act on the subsidy is stronger this time around because many are recovering well from the 1997 financial implosion, and is more acutely aware of bad economic policies. It is better to reduce the subsidy from a position of strength.

d) Consumption patterns have also changed owing to the present oil price rally, but isn't that the case every time there is an oil price shock? Drops in sales of SUVs (four wheel drives) and increase in purchase of hybrid cars are evident. The only difference is that the consumer is generally pretty pissed off with the magnitude and arrogance of the oil price rally over the last 12 months. There is a growing sense of the consumer not wanting to be an idiot victim of future oil price hikes, and also a warming appreciation of global warming and conservation issues.

e) Oil companies and refineries are also taken aback by the present oil price rally. Though they are all recording supernormal profits, many felt that they were caught unawre by the rally. These companies and governments have stepped up efforts to speed up on oil exploration and refineries have charged along to increase capacity.

The above factors would indicate that the price of oil will stay stubbornly high over the next 12 months at least as demand is still genuine, and supply is still not able to catch up that fast. Extra capacity and supply will come along only after a couple of years.

What is important here is that governments have generally wised up to the need to adapt quickly, either by reducing subsidy on oil prices or change in consumption patterns or increase activity in exploration - this should reduce the price volatility in the next oil price shock, and also indicate that future oil price shocks is more likely to be determined by demand factors again rather than supply constraints.

The final lesson here is that it used to be the trade surplus countries are subsidising the ballooning US budget deficit. Though naysayers have been plenty and more vocal over the last 10 years on the need to bring down the US budget deficit (and they should), the end for the US dollar is still a bit further away as there is sufficient petrodollars providing extra support for the deficit. Hence I would only really start to worry about a collapse in the US dollar and US economy if Japan and China stops registering trade surpluses or OPEC nations NOT making real money anymore, as it is not in anyone's interest to allow the US dollar and US economy to collapse. Having said that, I would think that certain US government officials are not too perturbed by the present oil price shock. In fact, it could work out better to further sustain the US budget deficit.