What is the Oil Price Telling Us?


Alrighty then. A bona fide rally. Now this is more like it.

The bear is out there somewhere, probably sleeping off his latest wealth destroying bender. This makes it safe for talking heads, bankers, and hedge fund managers to poke their heads up on television and talk about glimmers of hope. Stocks in New York are back at 1997 levels.

Back to the Future!

Your editor has been laid low by some sort of virus/food poisoning event from last night. We apologise ahead of time for the lack of vim and vigour in today’s letter. Maybe now that the rally has begun, our body is releasing the accumulated tension of the last six months…by repeatedly vomiting.

Notable in yesterday’s move is the 11% rise in oil to US$47. Oil is certainly not up on the basis of a huge ecomic rebound in 2009. So what is it? China’s been stockpiling oil while prices are cheap. It’s straegic reserve is now all full. OPEC is meeting to discuss more production cuts.

Those two facts suggest lower oil prices, not higher prices. But they also suggest that somewhere down the line this year, demand is going to spike for oil at a time when supply/production is in first gear. Is this what the oil price is telling us?

Who knows? Prices are supposed to communicate information. But sometimes they mumble. The Washington Times reports that China has wrapped up $41 billion in oil and energy deals with Russia, Brazil, and Venezuela recently. What’s the trade? Simple: cash for tangible goods.

Or, as the times puts it, “A series of high-profile energy deals and mining bids in the past month marked an end to the nervousness that appeared to impinge on Communist Party leaders at the outset of the global financial crisis. Attention has turned from hoarding foreign exchange reserves worth close to $2 trillion to locking up future supplies. Oil has emerged at the top of China’s shopping list.”

So this is how the dollar standard ends. Not with the floating of the yuan…but with the gradual swapping of dollars for dirt and energy. Seems like a good trade, although once people are on to it, watch out for the dollar. It could head lower…and oil and gold much higher.

It’s a tricky strategy, using debt to by assets like stocks and houses. The Federal reserve reports that American household saw their net worth fall by US$11.2 trillion in 2008. They lost 18% of their total net worth-wiping out the last five years of gains.

The houses are still there. And most of the companies are still there (with notable exceptions like the investment banking industry and maybe soon, GM). But the debt people used to lever up so they could get in on the great inflation in assets is still there.

Asset prices always regress to the mean. This cycle has seen a pretty mean regression. The really important question for 2009 is how central banks and governments will handle such large debt-to-GDP ratios when people are losing their jobs, seeing their incomes fall, and watching their asset values circle the bottom of the drain. If the past is any guide, you know they’ll inflate.

Did you see the Mother of All Perp Walks with Bernie Madoff? It’s amazing no one tried to lynch him.

That will have to be it for the day. We sense some, er, volatility as the market opens. Until Monday…

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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