Sunday, December 21, 2008

A little pain isn't a bad thing

Dec 20, 2008

By Tion Kwa

IF YOU drive, you'll like where oil prices are hanging out these days. You might even be thinking of cranking up the air-conditioner at home. So it might seem counter- intuitive to say that under US$40 a barrel is a bad place for oil prices to stay.

But it is. It's bad for everyone. Given where demand was just six months ago, today's oil prices reflect how badly and quickly economic growth has been pummelled into nothing. If you worry about the environment, low oil prices take away all the incentives from investing in expensive alternatives. And finally, if you're an oil producer, you're not making enough to look for new oil.

Honestly, it's a good thing barrels of oil might soon trade for more money. Or at least, we should hope they do.

But it won't happen because Opec says so. Which it tried to do this week, when it announced it was cutting production by 2.2 million barrels a day. No one believed the Organisation of Petroleum Exporting Countries when it promised to raise production when prices were high; no one believes it now when prices are low. Actually, no one knows why there's still Opec at all: It can't control its members, it can't control supply and it has no influence over prices. But that's another story.

One reason oil should be rising is that the US dollar finally is losing steam. Well, you'd think that it should. After all, the pair are supposed to move inversely to each other. Now, after the flight to the safety of US assets - more specifically, Treasury bills - during October and into late November, demand for the dollar has been quickly easing.

Yet, something odd happened. In the past few weeks when the dollar weakened, oil didn't rise. So where's the correlation?

In fact, correlations don't always match. They can change dance partners.

Sure, because oil is priced in dollars, it should be pricier if the dollar falls. But details like these aren't what investors and traders are looking at right now.

For the moment, the focus is on something more elemental: How much economic gloom is there going to be? The longer the economic slide continues, the longer will the demand for oil be depressed. The more countries slip into recession and the longer they stay there, the less people will be inclined to spend and to drive.

Now, if markets were perfect, there would be an index for all this. But markets are made of people, and people are not perfect. Perhaps that's why, despite the fact that people all over the world buy and use oil, it's only US demand, stock and draw-down levels that affect prices for everyone. Actually, it's really because the United States is the only country that keeps precise data and releases it regularly every Wednesday. It's not a perfect way to judge supply and demand. But it's the only one we have.

For the same reason, oil is looking at the US stock market for clues. Sure, the US isn't the world. But it's the most important economy. And for that matter, Wall Street isn't the American economy, either - but it's the only daily gauge of that economy. So again, it's not perfect. But it'll do.

In recent weeks, oil has been marching in step with the Dow, instead of inversely tracking the dollar. And if sentiments coming out of Wall Street hold out - that stocks have been building a bottom - then we're likely also to soon see a floor in oil prices. As long as oil doesn't decide to change dance partner again, petroleum should rise too.

The second reason oil should rise comes in two parts. First, current prices are encouraging those who can afford it to build up stock.

Next, repeated interest rate cuts in the US have made dollar financing cheaper. This lowers the carrying cost of futures contracts. Thus, oil traders will be more interested in rolling over contracts when they expire, instead of releasing the oil into the spot market.

To the extent that this happens - it's still early and this needs to be watched - it keeps out oil from the immediate- demand market. Together with support for prices that comes from stock build-up activity, this should move prices higher.

Finally, the pace of the decline in demand is apparently shrinking. That's not to say that it's a trend yet. And even farther from saying that demand is rising again. But it just might be that the really bad time from October is behind us.

Indeed, the best sign we can have of better economic conditions and future prospects would be to see oil taking a healthy leap forward of a few more bucks. Sometimes, a little pain at the petrol pump isn't a bad thing.

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