Rising oil prices are a warningBy David Morrison | 21 October 2010, 13:52 BST
David Morrison, GFT, CFD Market Strategist
Within two weeks we will know for sure if the US Federal Reserve is prepared to flood the market with further stimulus in the form of quantitative easing (QE). As current betting goes, it's odds-on that it is. Although there are a significant number of Fed members who have doubts about further monetisation, both Ben Bernanke and William Dudley, FOMC chairman and vice-chairman respectively, sound firmly in favour, and history suggests that they will take the majority with them.
The expectation of this additional intervention has had the effect of lifting all asset prices, not just equities. Commodities have soared, with cotton hitting a nominal record high this month and agricultural products such as corn and sugar also making headlines.
The price of a barrel of crude oil has spent most of the last twelve months trading between $70 and $80. OPEC (whose 12 members control around 70% of the world's oil reserves, and a third of its production) continually reiterates its opinion that between these prices, crude oil remains perfectly balanced for both consumers and producers.
This relatively narrow range stands in stark contrast to the volatility of a few years ago. Back in July 2008 we hit a high of $147 - partly thanks to the increase in Chinese demand which began in the 1990's, but also in the run-up to the financial crisis. Due to arbitrage opportunities between the cash and futures market, and uncertainty over the financial outlook which saw speculators look to crude as an alternative store of value to precious metals, physical crude was bought up and stored, driving prices higher. Then the financial crisis burst and the imminent recession saw crude plunge to below $40 in less than six months.
To counter this, in early 2009 OPEC cut production by 2 million barrels per day. Then coordinated monetary and fiscal stimulus from the governments and central banks of the world's leading economies kicked in. Prices soared, and asset classes began to correlate in ways that no one would have believed possible just a few years before. Twenty months later, and it looks like we're off again. Only this time the intervention won't be coordinated, and comes against a backdrop of threats about trade and currency wars.
With the recent dollar weakness pushing oil back to the top end of OPEC's target range, there has to be some concern of the effects that persistently higher oil prices will have on the wider economy. It is far from certain that Asian Pacific domestic markets are anywhere near robust enough to take up the slack left by the slowdown in the US and Europe.
After all, Europe and the UK are implementing austerity measures, while the US consumer (previously the buyer of last resort for the rest of the world) is seriously constrained by a depressed housing market and stubbornly high levels of unemployment. Asian Pacific countries owe their trade surpluses and growth to strong export markets, and all the evidence suggests that these markets are under pressure. Yet China is not yet ready to embrace welfare reform, a move which would, in time, give its citizens the security and confidence to save less and spend more.
Oil demand is still below the levels seen prior to the financial crisis and US inventory data suggests that supply is plentiful. Yet for now, crude oil looks like it will continue to push higher as the dollar falls in expectation of further quantitative easing. But with so much hinging on the US Fed, and with correlation making risk diversification near impossible, any miscalculation now could see volatility in all risk assets explode, with uncertain consequences.
Source: GFT UK