Crude Oil- The Issue

Just when you thought that subprime was going to fizzle out and the fear of the credit crunch was almost a thing of the past, you saw global crude dangerously flirting with $140 levels and a very realistic fear of US undergoing recession. It makes you wonder how the present global crisis against all odds is such a lethal combination of the credit crisis, slowdown and commodity and food price inflation. The reality seems much more connected than what we actually think. With subprime playing heavily on the American economy, the US Federal Reserve was in no position to let housing prices fall further along with much needed liquidity to bail out the ailing investment banks. The collapse of Bear Sterns would have most likely played havoc with depositors and investors and seen an overnight withdrawal of all investments and deposits. Though in the absence of the $200 Bn injection into the US financial system, a pre World War II- Great Depression like situation was almost imminent, yet the way in which the money came into the system may be argued. 

As the global and American economy was staring into the eyes of a slowdown, investor confidence in equity especially in developed world was at an all time low. With decoupling of the Asian economies also disapproved, the last thing any sensible person wanted to do was put in money into equities. Corporate debt was definitely an alternative but considering the sudden drop in sales and consequently margins and revenues, investors would any day prefer to remain at an arms length from any sort of corporate borrowings, long-term or short-term. The gradual easing of interest rates in the US was one reason for the rapid depreciation in the USD and an obvious consequence was a steep rise in the price of crude along with other commodities. Another important consideration is that the existing and newly injected money supply in the system would have to be invested in some instrument or the other and eventually it seems, most of the money lay invested in commodities. With the global economy barely growing by 3.5% in 2007 riding on the back of India and China inspite of the largest economy in the world shuddering from prospects of a recession, a modest estimate would be that oil consumption too went up in line with the growth [Though 2008 sees a forecast of oil demand rising by just 0.8%]. So has the supply really fallen since the demand has been more or less stationary? What really made oil price double in the past one year? Speculation of a fall in supply due to turmoil in Nigeria, Iran and a few other oil producing countries is said to be one of the reasons why the price of crude has really risen. However one must remember, during the American war in Iraq both at the times of George Bush Sr. and his infamous son, speculation of a supply shortfall was much stronger than what it is today. Even the discovery of massive oil reserves just offshore of Brazil couldn’t help decrease the price of crude. 

The present Bush administration seems to be cocksure that the present case of oil price is basic demand supply hike. Looks like the first citizen of America isn’t really aware of the amount of speculative capital in commodities right under his nose. With futures trading in oil going up by 100% at New York over the past year, it can be easily understood that the demand has been essentially created through artificial factors and the bubble will probably be the first victim of a resurgent world economy. Unfortunately, oil prices have a strong bearing on the global economical growth and at such high levels the economy will be tested hard to prove its resurgence. From our past experiences global economy will definitely hit back but the question is when? At this point of time an extremely likely situation of a steep increase in interest rates by Ben Bernake too cool inflation in the US would probably slow down the American economy further and delay a comeback on the industry’s part. Till the manufacturing and services industries don’t revive wages won’t increase and a rise in demand for industrial goods and services seems unlikely. Until then investor money will slowly move out of equities and seems to be safely locked into commodities. It looks like there has been selective picking and steep increases in various commodity prices. In 2007 we saw gold rallying and then it was food. Crude has slowly and steadily been rising in the past 1 year and it looks like very soon speculators will have to look for other commodities. From what it appears as of now, crude will remain stable at current levels for a certain amount of time and there will be a gradual fall in commodity prices only when we see a few good quarters by some of the big international firms and only then would confidence into equities and corporate debt be regained.

-Akhil Sharma