The Market Panic’s Effect on Oil

It hit. The panic, the mania we were all worried about - it has arrived.

Global markets dragged themselves through July, slogging through one potential catastrophe after another. Greece's financial troubles, worries about Italy, Ireland, and Portugal, slowing manufacturing and persistently high unemployment in the United States, inflation in China - troubling economic news dominated the headlines for the entire month, overshadowed only by Norway's tragic terrorist attacks. Yet the markets managed, mostly matching losses with gains to maintain forward momentum. Similarly, crude oil prices generally climbed and then fell, climbed and then fell, staying range-bound amidst the uncertainty.

Then came the circus around the U.S. debt ceiling, followed by Standard & Poor's downgrading of America's credit rating. In the week around those events, the S&P 500 dropped 7.2%. And the price of oil (West Texas Intermediate, or WTI) fell 17% from July 26 to August 8, hitting a low of US$81.31. Ten percent of that fall happened in the two days following S&P's downgrading of U.S. debt. On August 9 the price bottomed at US$75.71 before regaining some ground. In April, U.S. crude traded as high as US$115 per barrel.

And things are not very different in Europe. Serious national debt concerns in several European Union countries are pulling Brent North Sea crude prices down as well - Brent lost US$5.63 on August 8 alone, and then lost another US$5 in intraday trading on August 9 to touch below US$99 a barrel. It is a stark contrast to its mid-April peak above US$125, and even starker when you think that Brent still cost almost US$120 just ten days ago.

The U.S. Energy Information Administration (EIA) trimmed its forecasts for oil prices in the wake of the recent pullbacks in crude prices. The agency now expects WTI prices to average US$96 per barrel in 2011 and US$101 per barrels in 2012, down $2 a barrel each from its previous outlook. Even then, the agency essentially warned that things might actually be worse, writing, "These assumptions do not fully reflect recent economic and financial developments that point towards a weaker economic outlook and also contributed to a sharp drop in world crude oil prices during the first week of August. There is a significant downside risk for oil prices if economic and financial market conditions become more widespread or take hold."

Similarly, the Organization of Petroleum Exporting Countries (OPEC) cut its global oil demand growth forecast for 2011 and warned that it could cut the outlook further if conditions in major economies do not stabilize. In its monthly report, OPEC reduced the global demand growth forecast for the year by 150,000 barrels per day, citing poor U.S. economic growth forecasts and weakening Chinese prospects. If conditions in the United States, China, and Europe continue to worsen, OPEC says it will trim another 200,000 barrels off of its demand growth forecast. By way of context, that still leaves demand growth sitting between 1 and 1.2 million barrels per day for the year.

Nevertheless, if prices remain at current levels OPEC may start cutting production rates. According to Wall Street bank Merrill Lynch, Saudi Arabia's break-even budget price is US$95 per barrel this year and US$85 next. If prices settle close to those levels, the most important oil-exporting nation in the world will have little incentive to pump its oil out. Specifically, Merrill analysts believe that a Brent price below US$80 per barrel would trigger a "substantial output reduction."

The long and short of it is that oil prices have corrected - significantly and dramatically - amidst a global economy that is terrified of another U.S. recession and seriously concerned that the European Union will crumble because a few strong countries cannot save a raft of bankrupt ones. Add to that new data showing that Chinese inflation hit 6.5% in July, and we have a recipe for continued volatility for some time. Within that volatility, we do predict that the next few weeks will reveal more downside than upside for crude prices - there is just too much uncertainty, both real (in terms of major global economic questions that need to be answered) and emotional (in terms of investors, from individuals to institutions), for anything to sort itself out quickly or positively in the short term.

However, in the long term we remain bullish on oil, and falling crude prices will create buying opportunities for investors willing to take on the risk. The world's population is growing and demanding more energy every day; the two main sources of that energy are crude oil and coal. As such we see strong futures for both, even if the present is far from bright. (We also believe in uranium, as we've written about several times in these pages, but that is a story for another day.)

So what is an investor to do? Two key points jump to mind.

First, accept that this uncertainty, this panic, this mayhem, is going to last for some time. This is a crisis of confidence in economic stewardship - citizens around the world are realizing that national governments can and do lead their countries astray, and that many have been spending far more money than they've had for many years. Just like personal financial crises, there is no quick fix for serious national indebtedness.

Second, think about how you might be able to profit from the situation. If you have some cash on hand - cash that you don't need to pay the mortgage or buy the groceries, that is - there will be some serious bargain shopping opportunities cropping up. When investors panic they tend to throw the baby out with the bathwater, meaning they see a sour market and ditch all of their investments, even those that don't deserve the toss. That creates buying opportunities, as shares in good companies become available for less than they should be.

But bargain shopping in an economic crisis requires even more due diligence than usual. Look for companies that can boast at least one of these three traits: lots of cash; low production costs; and low to zero debt. Cash enables a company to keep on keeping on even if their debt vehicle hits a pothole or the general markets plunge, and allows the company to jump on acquisition opportunities. Low production costs give a producer breathing space when commodity prices fall - a project based on US$100/barrel oil is already floundering, but one based on US$50/barrel is still doing just fine. And like so many homeowners have discovered over the last few years, it doesn't matter how much one makes if one simply can't pay one's bills.

It is very easy to feel lost in this kind of chaos, to feel that things are so complicated and so broken that there is nothing an individual could do to change the outcome. Well, perhaps you can't change the overall outcome for the European Union, or figure out a way to fix the major disparity between the amount of money the American government takes in and the amount it spends, but you can move to protect you and yours. If you don't, no one else will.

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