Unrest and Turmoil Equals Rising Oil Prices

Fri, Mar 25, 2011 - 8:07am

The continuing political upheaval in North Africa and the Middle East along with the epic disasters in Japan are sowing chaos and confusion throughout the business world. In this week’s newsletter, we will examine just how all this is playing out.

Let's look at the Arab world first, which is being shaken to the core. Starting with Tunisia at the end of last year, serious civil protests, armed conflict, and unprecedented criticism of repressive governments have erupted in places like Egypt, Bahrain, Yemen, Libya, and Syria.

In total, nine of the eleven nations sharing land or water borders with Saudi Arabia have experienced demonstrations. The Saudis government is feeling the heat and has dispatched forces to quell protests in Bahrain. Trouble is likely to surface in Saudi Arabia because much of the country’s wealth is located under lands where Shia Muslims are in the majority. Keep in mind that the ruling House of Saud is Sunni Muslim. The distrust and bad blood between the two sects predates oil discovery and is not likely to be solved with oil money.

The current political events in the Middle East are about freedom from repression but also represent a basic struggle between these two Muslim groups for control of revenues from the huge oil fields in that part of the world.

Saudi Politics and Energy

The events in the Saudi neighborhood are spooking many investors. Egypt and Tunisia set the stage with some violence but had an eventual transition. Bahrain and Yemen are experiencing violent demonstrations and a strong government response. Libya has developed into a civil war that now includes NATO involvement. Investors are concerned that Saudi oil fields may eventually come under fire and if production is diminished or halted a rapid rise in the price of oil will ensue.

Historically, Saudi Arabia has been the swing producer that supplements global oil supplies during times of international crisis, oil shortages, and high oil prices. Its actions in those situations have kept prices relatively stable. Examples: the Kuwaiti oil crisis and the Iraqi production declines.

Today, many experienced oil observers believe the Saudis have limited ability to increase production of high quality crude to help the world withstand a shortage situation. Moreover, their costs to produce oil are rapidly rising. The Saudi government recently stepped up funding to religious establishments, public sector salaries, pensions and payments for the unemployed and underemployed to the tune of $38 billion dollars per year. Some analysts suggest this adds $10 to the price of every barrel of Saudi oil produced this year. They think that social welfare costs are now so high that the government will want to keep oil at $90 dollars per barrel. Therefore we do not expect the Saudis to provide relief at the pump by quickly increasing supplies should oil prices fall much below current levels.

Add into the equation that Saudi Arabia has the ability to increase production by only about 2 million barrels a day — which may seem like a lot, but not to a world that is expected to consume 89.4 million barrels daily in 2011. That’s a drop in the bucket. A tight supply and demand situation remains.

Elsewhere: Oil Supply Growth is Elusive

Outside of the Middle East and North Africa, other major oil-producing states are having their own problems and failing to make good on promises to expand production.

Nigeria is plagued with terrorism, corruption, and national budget deficits that have hampered its ability to pay its share of oil exploration costs.

In Venezuela, production has been sputtering for years, a result of Dictator Hugo Chavez’s purge of experienced technocrats in the national oil company in favor of less qualified individuals who support his regime. Fed up, many of the nation’s educated and professional class have headed for the exits and left Venezuela, and who can blame them? Perhaps in a joke, but more likely reflective of his attitude toward the business world and the U.S., Chavez suggested recently that capitalism could be to blame for why there is no life on Mars.

Along with these developments, Norway and Mexico have both experienced oil production declines in recent years.

Meanwhile, Oil Demand Grows Steadily

What Does All This Mean to You?

Look for oil prices to hit $150 per barrel in 2011.

Japan: Opportunity Follows Radiation Panic and Supply Chain Problems

Japan has suffered many devastating earthquakes and tidal waves in its history. According to experts, however, previous known earthquakes appear to have been small fry — less than 1/4 the magnitude — in comparison to the March 11th event. They say it was the largest quake to occur in 1,200 years along the Pacific tectonic plate. The initial shock alone was about 100 times stronger than the quake that hit Haiti last year. We are saddened by the scope of the tragedy, suffering, and great loss of life.

The epicenter under the ocean floor was located 110 miles away from the Fukushima Daiichi nuclear power plant on Japan’s northwestern coast. Damage to the facility has captured media and world attention, and in the process stoked a good deal of imagination, fear, and panic.

Japan has over fifty other nuclear reactors, and the other plants in affected areas switched into shutdown mode during the quake, just as they were designed to do. We have spoken to clients and friends who are nuclear energy experts and all of them state that this is not a Chernobyl-type of disaster and the probability of airborne radiation seriously contaminating other parts of the world is remote.

Japan has virtually no natural energy resources. It must continue to rely on nuclear plants to produce electricity. The Japanese have always been able to recover and regain strength, bolstered by a national industriousness and engineering excellence. The challenges this time are huge, but if electric services can be quickly restored to the country as whole we expect to see solid economic recovery from the disaster.

Thus, economically we do not believe that the disaster’s dislocating effect on world trade is nearly as serious as pessimists contend. We strongly believe that Japan represents a good long-term buy at current levels, and maintain our existing buy recommendation on Japan.

Emerging Markets: A Mixed Bag

Several emerging Asian markets may experience a temporary hiatus from the rising inflation that’s been in progress for the last nine to twelve months. This hiatus would be the result of rising interest rates. The slowdown in inflation suggests a base-building phase now. Many investors see a period of a few months where interest rates will not rise and these expectations are creating an increase in capital inflow. New investors are circling growing companies in the Southeast Asian region. Emerging Asia, of course, looks strong over the long haul because of its growth profile.

Among other important global markets, India is reeling because of virulent inflation combined with corruption scandals engulfing many parliamentarians. Investors are in a holding pattern regarding Brazil, as they try to assess the direction and skills of their new president, Dilma Rousseff. Elsewhere in Latin America, things aren’t so hot. Russia, meanwhile, looks good due to its strong position in oil and minerals.

The U.S. Dollar: Headed Lower, So Protect Yourself

During the period of QE2 — since last November — Washington has monetized all of the U.S. debt. Some argue that the amount is actually close to 110 percent. Part of the money is located in the U.S., but a substantial portion is held abroad. Foreign-held dollars represent a danger. Holders may not think in dollar terms but rather in terms of their own currency, and may dump dollars to buy a substitute currency with more upside potential. The dollar is thus at a critical juncture on the technical commodity charts.

Should the dollar break down, the Fed would be forced to buy more bonds as foreign sellers seek to diversify their assets out of dollars. Many have already done so in the past few years. This and other trends are causing a continuing decline in U.S. dollar appeal.

Another dollar-shaking trend is an inflationary pressure within an emerging world inexorably moving into developed world status due to a rise in the standard of living. With this rise comes demand for goods and services. More demand for goods leads to higher prices unless the supply can be increased. However, in the case of food, energy, and many other raw materials, the supply is fairly fixed.

So, two major influences are at work here:

  1. Monetization of debt in the U.S., as well as Europe and Japan
  2. The Growth of demand for goods, food, and energy around the world

Both influences conspire to create a very unpleasant surprise, as well as suffering for the unprepared, down the line. Initially, we’ll see a weaker dollar and higher inflation. That’s a bad combination any way you look at it, especially for individuals on fixed income or those who wish to keep their standard of living intact.

What Does This Mean to You?

Hold your cash whenever possible in currencies other than the U.S. Dollar, Euro, or British pound.

Golden Days Continuing

More countries are buying gold. Iran has disclosed a shifting for some time now out of dollars and into gold. Turkey has been buying up gold.

Gold has soared to more $1,400 per ounce but still central banks keep going to gold as a store of value in these volatile times. After a stunning run for 10 straight years it seems too much to think that gold can rise any further at this time. Clearly, there is reason to expect a breather. However, the combination of higher consumer demand (a result of growing global consumer wealth), currency instability, and political turmoil and conflict, is fueling a strong demand for gold. We expect the gold rush to continue so for a least the next year or two.

About the Authors

Chief Investment Officer
guild [at] guildinvestment [dot] com ()

tdanaher [at] guildinvestment [dot] com ()