The Emerging Markets Insider

What's up with oil!

Much of investors' concerns in the U.S. and around the world has to do with skyrocketing oil prices and what they pay at the pump. Crude oil per barrel continues to tap new highs and is flirting with the $120 mark. Yea yea, I can just hear you now: Shut up already about oil, it's all we hear about on the news lately - that and politics and Britney's latest meltdown - enough already!

Look: I know you've been hearing about oil until you're sick of it, and I know you'd rather not be reminded what you're paying at the pumps these days, but it is an important factor in the global marketplace and bears a little discussion...

Is oil going straight to $200? No! I expect the volatile rocket ride in oil pricing and gasoline to continue, as supply tightens and the U.S. dollar continues to struggle against other currencies. But I don't expect we'll see a dramatic increase from current levels - the odds are more likely we'll see a retracement of some kind (and I'm looking into a number of potential trades for you to leverage this bet, so stay tuned).

You see, because foreigners such as OPEC (Organization of the Petroleum Exporting Countries) -- the 12 big oil producing countries -- must sell their oil in U.S. dollars and not their own currencies (which have all appreciated substantially against the dollar over the past several years, in part because of their oil-based economies), they are automatically receiving a discounted price for the oil on the open market. Therefore, these countries have to keep increasing oil prices just to compensate for the weak U.S. dollar.

So the net effect of oil being denominated in dollars is a loose but clear inverse correlation between the two. There are times they do not move inversely with each other, but that's when other factors are exerting a stronger influence - the dollar factor is always an important factor in oil pricing. This is an important distinction.

On the other hand, when oil prices increase for dollar or non-dollar reasons, it crimps the U.S. consumer and consumption -- which in turn tends to put downward pressure on the dollar due to the threat of a weakening U.S. economy. It's the proverbial vicious circle!

And much of the recent pop in oil prices also has to do with short-term causes, such as Nigerian oil supply being crimped -- again -- by terrorist attacks on their pipeline, a pipeline shutdown in the North Sea, and a 2-day strike (now resolved) by oil refinery workers in Scotland. Wait a minute... SCOTLAND?? When the heck did they get in the oil picture!? What the heck. Just goes to show you how the plot can thicken in an unexpected way at any moment.

Anyway, the point is that the future of oil prices and the effect that it will continue to exert on the U.S. and world economies is a slippery matter to get a hold of.

Let me put it this way. I sure wouldn't want to be driving an 18-wheeler for a living right now. My nephew Christopher does just that, and he tells me it costs him over $1000 to fill his tanks one time - and that it's almost not worth it anymore since he and other truckers haven't been able to pass the full increase in fuel expenses onto their clients.

Christopher made headlines and got repeated hero coverage on CNN after Hurricane Katrina. He, along with his faithful boxer "Brooklyn," who travels with him everywhere, was volunteering to assist FEMA with that nightmare, initially transporting food, water and supplies to the Superdome-turned-shelter. After unloading his supplies, Christopher took in upon himself to save a good many Katrina survivor in dire need of medical attention, by running his rig repeatedly through deep water between the Superdome and the medical center. No other truck driver would brave it (there were thugs sniping at relief workers and the waters were dangerously contaminated) or risk the near-certain and very expensive water damage to their rigs. 18-wheelers aren't amphibious vehicles. Well, his truck was gravely damaged by the deep water run (and FEMA wouldn't help with the costs), but he got the patients where they needed to go and I'm sure saved more than a few lives.

Back to oil prices. Looking at the dollar's relationship with oil from another direction, a strengthening dollar could help drive oil lower: If the dollar begins to strengthen due to either a perceived strengthening of the U.S. economy, a weakening in the other major currencies, or a pause in cuts (or an actual increase) in U.S. interest rate levels. oil will be come relatively cheaper, all else equal. Higher interest rates will typically tend to assist the local currency since higher interest rates will attract foreign investment and support the local economy.

Then, there's supply and demand. Some short-term S/D is driven by the likes of pipeline disruptions and strikes I've alluded to above. Long-term S/D will be controlled by how much oil is in the ground and what other competing energy technologies becomes mainstream. But there's more behind oil pricing than S/D or the dollar's weakness...

Much of the current price of oil is based on speculation and driven by the futures market. Depending on which expert you talk to, between $30 and $60 of the current level of $118 per crude barrel is speculation, not driven by the actual oil markets. That beast lives in a cage all by itself. As we've all seen in other markets, speculation can go well beyond where logic dictates. I personally expect oil to spike a little further short-term, then correct to $90 to $100 mid-term, without some game-changing geopolitical or macro event, such as Iran acting up in the Persian Gulf.

Best wishes,
Jeff Manera
Emerging Markets Insider
Email: Jmanera@EmergingMarketsInsider.net