from Follow the Money

$140 oil

June 6, 2008

Blog Post

Call me surprised.

If you had asked me two years ago if oil could come close to $140 amid a US slowdown in the absence of a major interruption in supply, I would have hedged a bit, but ultimately said no.

I understand the logic that argues that weak US data implies low US interest rates -- and low US interest rates, in various ways, push up the price of oil.

But weak US data also implies a weak US economy, and the US remains the world’s largest consumer of oil.

Some players in the market also seem to have been caught by surprise. Short-covering seems to have contributed to today’s large move. The FT’s Michael Mackenzie, James Politi and Chris Flood report:

Traders who had bet on falling oil prices through short sales - in which they selll the commodity in hopes of buying it back later at a lower level - were forced to cover their positions, sending oil prices skyrocketing.

Wall Street banks contributed to the rally as they bought crude oil futures to cover their obligations under agreements that compensate investors and companies such as airlines if crude rises above $140 a barrel.

Jim Hamilton is right: this looks like a major oil shock. At $140, oil would be twice its average level in 2006.

$140 oil for the rest of the year implies an average oil price for 2008 of around $120 (maybe a bit higher)

Concretely, a rough calculation would suggest that this implies that the US will spend about $250 billion more on oil imports this year than last year. I don’t quite see how the US trade deficit can improve in the face of that kind of shock.

It implies a comparable increase in the oil import bills for Europe (which imports a bit less than the US) and the major oil importing economies of Asia (which together now import a bit more than the US) -- and a roughly $750 billion increase in the revenues of the major oil exporting economies.

Some will be spent - or used to finance domestic investment. But a lot will be saved.

I had estimated that if oil averaged $115 for the year, the Gulf would add roughly $400 billion to the coffers of its sovereign funds and central banks. Just to be clear, this is money that is invested abroad; the various domestic investments of the big Gulf countries aren’t counted -- even if they are done by a sovereign fund or a subsidiary of a sovereign fund. Overall official assets of the oil exporting economies might increase by something like $800 billion.

That would be roughly twice my estimate for the increase in their assets -- excluding capital gains -- in 2007. And $400 for the Gulf and $800 for all the oil exporters now looks like an underestimate. $450b and $900b look more likely now ...

Don’t be fooled by the fall off in big, visible headline grabbing investments by sovereign funds. The oil exporters are sitting on a lot of cash. The amount of interest in how institutions like ADIA allocate their portfolios is only going to grow.