Oil Crisis Stagflation Spiral Special

By: Nadeem_Walayat

Crude oil continued to hit its new all time high of $128 today by closing above $127 for the first time, up 96% in 12 months and 165% in 3 years. The impact of the price hike is both inflationary and deflationary at the same time. Inflationary as oil is the life blood of the functioning of global economies and thus resulting in across the board price hikes. Deflationary impacts as the price hike acts as a tax on the consumer from fuel pumps to food stores thus leaving less money in the hands of the consumer to pay for the necessities let alone for luxuries.

This is creating a spiraling stagflationary environment, as on its own the western economies could have coped with the oil crisis, but having been hit with the triple whammy of deflating housing markets that itself triggered the bursting of the credit bubble that continues to deepen as banks fail to report the true extent of the crisis on the interbank LIBOR market.

Under historic circumstances one would imagine that in such a weak economic climate, the price of crude oil would start to retreat in the face of growing recessionary forces across the western world. However it is not and the primary reasons for this are:

1. The surging demand for crude oil amongst the emerging markets, where the anticipated reduction in demand in the west will be far outstripped by the increase in demand from the emerging markets , namely China and India, and to an increasing extent Russia. Crude oil demand continues to grow by more than 1% per annum with no sign that this will be brought to a halt despite the oil price flirting with $130.
2. PEAK OIL – The rate of increase in oil production is slowing as crude oil becomes harder to find and more expensive to extract. Many of the big oil fields from which oil is cheap to extract are ageing with output reductions already being observed across the oil producing nations big fields. This suggests that crude oil production will peak during the next 5 years. The rising price of crude oil will enable more costly oil fields to be brought on stream therefore oil production may plateau for some years whilst at the same time demand continues to rise. The consequences of which will be ever higher prices and inflationary forces.
3. The 40% devaluation of the US Dollar during the past 12 months or so has contributed towards the surge in the price of all dollar denominated commodities including crude oil.

Therefore the price of crude oil is not falling despite attempts to increase supply as witnessed by the pressure put upon Saudi Arabia to increase its output that resulted in Friday's announcement of an additional 300,000 barrels of day of Saudi output, which given the market reaction was seen as insignificant.

The clear consequences of a stagflationary environment are most evident in the decline of real interest rates, where even the discredited official inflation measures such as the CPI are unable to offer a positive return to savers. US CPI stands at 2.3% against a Fed Funds rate of 2% and therefore a negative yield on short-term treasury bills. The longer end of the yield curve is much harder to manipulate than the short-end and is correctly discounting higher inflation and the need for rate rises to combat this and hence the 30 Year Bond is yielding 4.375%.

Crude Oil Technical Outlook

(Chart courtesy of stockcharts.com)

The current phase of crude oil's bull market began with a cross above $100 during late February which targeted a move to $115 (the width of the corrective pattern), crude oil blew through that target towards its current level of $127.50. To say that crude oil is now overbought on a technical basis would be an understatement. The immediate trend is difficult to ascertain as given the fever currently gripping the oil market, the price could exhibit a panic driven spike straight through $130 up through $140 within a matter of weeks. Looking beyond the chance of a possible spike, crude oil seems destined to decline towards the $110 support area to work out at least some of its overbought state. Therefore such a correction could provide investors with a further opportunity to accumulate for the long-run.

How high will crude oil go? That depends on ones time horizon. My expectation remains for crude oil to hit $150 this year, 2008.

To benefit from crude oils inexorable long-term trend towards $200 plus suggests long-term investments in oil companies both large oil majors that remain fairly priced, and the more volatile smaller exploration companies. To spread the risk investors should target investment funds and investment trusts. An alternative is to invest in ETF's that track the oil price directly such as the United States Oil Fund (USOF).

The wealth being accumulated by oil producing countries, that despite a devaluation in the US dollar presents further long-term investment opportunities in the better managed Gulf states, Russia and not forgetting the Canadian oil sands. These economies are expected to boom on the back of huge oil revenues deployed in their industrialization and infrastructure projects, unlike much of the rest of the world, these countries will not need to worry about where they will get their oil from to fuel their economic growth.

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By Nadeem Walayat

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Nadeem Walayat has over 20 years experience of trading, analysing and forecasting the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 150 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

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