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Oil Market Resolution for 2009
Posted: 16-Dec-2008
Posted: 16-Dec-2008
Oil prices below $50 a barrel is an anomaly and defies the fundamentals. OPEC will soon trim its quotas by 2 -2.5 million barrels a day, reaching a cumulative cut of 4-4.5 million barrels since last September. OPEC countries will adhere to about two thirds of the total cut. It may need to cut again in February to reduce the gap between the announced cut and the actual reduction. Putin will also give a helping hand to OPEC’s cut. The cost of marginal oil well in deep water is $70 a barrel and oil sand extraction in Canada requires a price near $50, otherwise the oil market is digging a deep trap for the future. Demand destruction has turned into supply destruction, with OPEC and non OPEC oil producing countries scaling down, deferring and canceling oil projects.
All those factors are part of the oil fundamentals. We believe oil price should be above $50 a barrel and should target $70 near the end of 2009. The credit, stock, foreign exchange and commodity markets and maybe the economy are setting the stage for the oil price to bounce in the range of $50-$70 in 2009. This is the oil market’s resolution for 2009. Political and economic factors are pointing towards a drop in credit risk and an increase in risk appetite by the end of the first half of 2009. By then, there will be a resolution of the big Three predicament, the TARP effect will start working, the new administration should start functioning and earnings expectations should start turning the corner.
The increasing risk appetite process will be facilitated by credit expansion of consumer and commercial loans, and mortgages in the United States. Thus, the credit market will be on the oil side in 2009. The increase in risk appetite will generate a movement from low yielding dollar- denominated assets to higher yielded assets dominated in non dollar currencies. This should be the result of a fall in risk aversion and the reduction in the usefulness of the dollar as the safe harbor at times of heightened risk. The volatility and fear index, the VIX, fell precipitously from a record of 90 to about 50. The comeback of the commercial paper has led to more than 50 percent fall in LIBOR between October and now.
The aggressive US monetary policy is also going against the dollar. The net effect of the overall drop in risk aversion should help exert downward pressure on the dollar, and consequently shore up oil prices. The inverse relationship between the dollar and the oil price has been documented and justified. The dollar in 2009 should also be on the oil side. The lowering risk and increasing risk appetite process should also be accompanied or preceded by improving stock market. This market is currently groping for the final bottom as it keeps testing previous bottoms.
The market has not yet reached the final bottom as evident by results of the fourth quarter survey of corporate CFOs, Tobin’s Q and the cyclically adjusted price to earning ratio. The CFO survey shows that US CFOs are still very gloomy about corporate earnings in the fourth quarter. Tobin’s Q, which is the ratio of market value over replacement value, is about 0.7 for the S&P 500, implying that the stocks are undervalued. The range of this ratio for U.S. stocks is 0.3-2.9. It achieved the maximum value in 1999 and the minimum level in deep recessions such as the 1982-83 recession. This ratio has thus more way to go down to reach the bottom, compared to the deepest recessions since the Great Depression.
The stock market will search for a bottom in the first quarter of 2009. It should first test the lowest bottom it touched in November. But since stocks are forward-looking and precede economic recoveries six to nine months and that many economists and financial analysts forecast an end to recession by the end of 2009 or beginning 2010, then we should see the stock market hitting a bottom roughly in March or June 2009 or in between. When this happens, the stock market will push the oil market up and oil prices will move and stay above $50 a barrel. The oil market should gallop behind the stock market. Thus, the stock market will be on the side of the oil market in 2009. Gold getting wet by all the liquidity coming out from the world’s central banks is sensing inflation in 2010-2012. It keeps trying to stage a rally.
Research has shown that gold price precedes oil price. Therefore, oil market should expect help from commodity markets in 2009. Given all the above help, OPEC in its forthcoming meeting on December 17th is in a better shape than in its last October meeting to help the oil market realize its resolution for 2009. But will OPEC do that?
Shawkat Hammoudeh is professor of economics and international business at Drexel University. Previously, he worked for Organization of Arab Petroleum Exporting Countries (OAPEC).
All those factors are part of the oil fundamentals. We believe oil price should be above $50 a barrel and should target $70 near the end of 2009. The credit, stock, foreign exchange and commodity markets and maybe the economy are setting the stage for the oil price to bounce in the range of $50-$70 in 2009. This is the oil market’s resolution for 2009. Political and economic factors are pointing towards a drop in credit risk and an increase in risk appetite by the end of the first half of 2009. By then, there will be a resolution of the big Three predicament, the TARP effect will start working, the new administration should start functioning and earnings expectations should start turning the corner.
The increasing risk appetite process will be facilitated by credit expansion of consumer and commercial loans, and mortgages in the United States. Thus, the credit market will be on the oil side in 2009. The increase in risk appetite will generate a movement from low yielding dollar- denominated assets to higher yielded assets dominated in non dollar currencies. This should be the result of a fall in risk aversion and the reduction in the usefulness of the dollar as the safe harbor at times of heightened risk. The volatility and fear index, the VIX, fell precipitously from a record of 90 to about 50. The comeback of the commercial paper has led to more than 50 percent fall in LIBOR between October and now.
The aggressive US monetary policy is also going against the dollar. The net effect of the overall drop in risk aversion should help exert downward pressure on the dollar, and consequently shore up oil prices. The inverse relationship between the dollar and the oil price has been documented and justified. The dollar in 2009 should also be on the oil side. The lowering risk and increasing risk appetite process should also be accompanied or preceded by improving stock market. This market is currently groping for the final bottom as it keeps testing previous bottoms.
The market has not yet reached the final bottom as evident by results of the fourth quarter survey of corporate CFOs, Tobin’s Q and the cyclically adjusted price to earning ratio. The CFO survey shows that US CFOs are still very gloomy about corporate earnings in the fourth quarter. Tobin’s Q, which is the ratio of market value over replacement value, is about 0.7 for the S&P 500, implying that the stocks are undervalued. The range of this ratio for U.S. stocks is 0.3-2.9. It achieved the maximum value in 1999 and the minimum level in deep recessions such as the 1982-83 recession. This ratio has thus more way to go down to reach the bottom, compared to the deepest recessions since the Great Depression.
The stock market will search for a bottom in the first quarter of 2009. It should first test the lowest bottom it touched in November. But since stocks are forward-looking and precede economic recoveries six to nine months and that many economists and financial analysts forecast an end to recession by the end of 2009 or beginning 2010, then we should see the stock market hitting a bottom roughly in March or June 2009 or in between. When this happens, the stock market will push the oil market up and oil prices will move and stay above $50 a barrel. The oil market should gallop behind the stock market. Thus, the stock market will be on the side of the oil market in 2009. Gold getting wet by all the liquidity coming out from the world’s central banks is sensing inflation in 2010-2012. It keeps trying to stage a rally.
Research has shown that gold price precedes oil price. Therefore, oil market should expect help from commodity markets in 2009. Given all the above help, OPEC in its forthcoming meeting on December 17th is in a better shape than in its last October meeting to help the oil market realize its resolution for 2009. But will OPEC do that?
Shawkat Hammoudeh is professor of economics and international business at Drexel University. Previously, he worked for Organization of Arab Petroleum Exporting Countries (OAPEC).
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Community Comments (4)
This would tend to suggest that the DFM has not hit bottom yet, although at over 70% down it can not fall that much further now. Local factors like liquidity and the sudden house price crash are complicating factors, see:
http://arabianmoney.net/2008/12/21/dubai-stocks-crash-back-to-the-bottom-again/
Image or perception matter more than temporary oil price increases.
The Psychology leading to a market bottom is one laden with total disbelief that it could drop even further. You are factoring fundamentals into the market. Fundamentals are not the problem, long term fundamentals will reassert themselves.
The problem All of Opec has right now is a total loss of "Face". There is no Leadership. A cut of 4-5 mil. brls. was needed to offset demand reduction.
The perception that the world will stop trying to use other energy sources if oil is cheap is flawed. The rest of the world sees it as an opportunity to reduce its oil use at a time when it costs them less to do so.
Opec is now funding the Next Generation of non-oil technologies.
Let me focus my comments on the oil price and alternative sources of energy. Whether we like it or not, people both investors and consumers are rational in their decision- making over the longer run. When investors decide to spend money on producing a new good or product, they place profit on top of their agenda. Production cost is half of the profit equation. Producing new sources of energy by the private sector fits well with the profit equation. Producers must make sure that the production cost is equal to or less than the price of the substitute, which is oil in this case. If oil is too cheap, this will delay the production of new energy types, which takes a generation to produce if the business environment is suitable. Volatility of oil prices, not just their levels, also delays production of new energy sources. Sometimes and this is rare, new technology can be invented by accident. This is not the case for the non-oil energy. Let us not become too emotional!
The Gulf stock markets, like the markets of the other countries, are currently suffering from a double whammy: The global financial crises and the world recession. The net effect for the Gulf countries is a semi collapse of the oil prices. The latter effect brings special panic to the Gulf.
This is a price that Gulf economies must pay for getting the good and bad from the oil price. They also receive good and bad from their investments in the west. You may review my blog on Gulf countries’ financing the US current account. They basically put their eggs in the western basket which contains a lot of banks and real estate companies, and this has maximized their bad.
There is more life left in the current global recession, and there are more negative effects on the oil price in the first half of 2009. The US stock market is heading toward the bottom in the first half of 2009. The recession will linger on until the end of 2009, and may be later than that. Since stock markets are forwarding looking, stocks will move up six to nine months before the economy. The Gulf stocks will have to wait longer than the US stocks until OPEC succeeds in stabilizing the oil price at $50 or more. OPEC can stabilize the price with the help of the fundamentals, but if it acts like the Federal Reserve.
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