Oil becomes choice asset as turmoil abounds

February 22, 2011 06:00 PM

“Life is the sum of all choices.”

Albert Camus

Market views

Geopolitics around North Africa and the Middle East continue to dominate all financial and commodity markets, especially the oil complex. The perception that contagion around the Middle East will spread, coupled with a view that higher oil prices... to some degree... are here to stay for the foreseeable future, has completely turned the market sentiment to a risk off sentiment for just about everything with the word asset in it except for oil and precious metals. Over the last 48 hours, traders and investors around the world have shed risk by selling equities, most all commodities (again except oil and precious metals) and moved the cash into precious metals and bonds, but not so much into the US dollar which is actually on the defensive this morning. The selling of equities is based on a growing view that higher oil prices will eat into corporate profit margins as well as force many companies to raise the price of their goods and services, thus potentially reducing demand by the already nervous consumer. In addition higher oil prices will ultimately result in inflation and force the hand of the developed world to prematurely move from their easy money policies to a tight money policy via raising interest rates to mitigate inflation risk which will result in a slowing of the economy and thus a reduction in commodity consumption in general.

As market dynamics move to find an equilibrium between all of the views of what the markets may look like in the short- to medium-term prices for everything have been and will continue to be very volatile with the central theme of reducing risk in one's investment and trading portfolios while the commercial sector ponders adding hedges to reduce the exposure of even higher oil prices. At the moment, it does not seem to matter in the marketplace that there is ample supply of oil around the world with commercial stocks of crude oil and refined products still running at above normal levels, over 100 million barrels of oil in floating storage, a Strategic Petroleum Reserve in the IEA countries (which the US is part of) of around 1.6 billion barrels, an unknown volume of oil in China's SPR along with about 4.6 million barrels per day of surplus crude oil capacity in OPEC. Barring a spread of the discourse to Saudi Arabia with a resulting shut-in of production in Saudi Arabia, the world can easily handle a shut-in of production from Libya, Algeria and even Iran for a reasonable period of time without the consumer seeing a shortfall in oil supplies.

That said, even with all of the above cushions there is a substantial risk premium of someplace between $10 to $15/bbl already built into the price of oil (higher end of the range in Brent, lower end of the risk premium range in WTI...my estimate). As long as the protests continue in oil producing nations, the risk premium is not likely to recede anytime soon and if the market believes it will spread even deeper than it already has, the risk premium will increase even further.

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