Of Oil and the Irish Debt Crisis
Today we are seeing some drawback in oil pricing as a result of the problems in Ireland. The pullback will test the $80 support level and once again indicate how vulnerable commodity markets are to perceptions of credit weakness.
The problems may focus solely on the fiscal picture in Dublin right now. But given the interconnection of the European Union’s common economic and finance space, they tend to impact everybody on the continent. The entire Eurozone experiences pressure against other currencies when this takes place, for the simple reason that the value of the currency essentially represents the underlying strengths of those economies.
The knee-jerk reaction is to translate a financial crisis into a decline for overall oil and oil products demand. That is true, but only as far as it goes.
For there to be a genuine hit to the demand side, this crisis must extend out for some time and have a tangible (and data-driven) effect on the domestic manufacturing, transport, and service sectors.
So any withdrawal of crude prices at this point, in expectation of that demand slide, is very premature.
You see, the integration of the E.U. composite economy prevents the possibility of an overall collapse of Ireland (or Portugal, or Greece, or Italy). However, Brussels does have a penchant for moving slowly on bailouts, with considerable discussion required before the structure of the package is resolved. And even then, it also takes some time for the Irish (or Portuguese, or Greek, or Italian) government to swallow its pride and step up to the credit window. (And there is always the possibility that the package will require supplement.)
Over the weekend, Dublin finally agreed to a loan package. Now the markets are digesting whether the package is sufficient, what the consequences are going to be, and who in the Eurozone is likely to be next on the bailout bandwagon.
When such bouts of falling confidence take place, the euro comes under pressure. That results in a bounce of the value in the dollar against the euro. This has been happening for the past week or more as concerns heightened over Irish solvency.
And this introduces the immediate reason for the decline we’ve seen in the oil price.
As you probably know, global oil transactions take place overwhelmingly in dollars. So the exchange rate between the dollar and the euro is a matter of some importance.
However, while the trade in crude is denominated in dollars, the domestic sales of processed oil products are not.
Throughout Europe, that business will take place in euros or Swiss francs or British pounds – but not in dollars. The effective purchase price will creep up a bit, with a corresponding discount provided for the dollar.
The retail “spot of sale” price drives this market. Normally, available supply of and demand for product determines pricing. But the current European credit concerns act as a temper.
The constriction in available credit (notice a major part of the bailout package requires that Ireland also restructure its banking sector) creates the fear of a ripple effect – lack of credit, decline in investment, loss of employment, rise in instability, and decline in demand for energy.
As the euro weakens against the dollar, it takes fewer dollars to match the euro, and the crude price (in dollars) declines. That is, of course, when everything else is equal.
But that is not the case right now…
Declining Stockpiles, Growing Demand, and A New Benchmark
Notice three things that have happened of note over the past several trading sessions.
First, the inventory stockpiles of both crude oil and refined product have declined.
Second, despite the problems in Europe and reports today about a continuing sluggish recovery on both sides of the Atlantic, demand is bottoming out, and an increase is developing.
Take a look at the numbers.
In its latest rig count, released this morning, Baker Hughes Inc. (NYSE:BHI) reported that the U.S. oil rig count has increased to 731 – the 15th gain in the last 18 weeks. At this time last year, that number stood at 375. In June of 2009, it was just 179.
That is an additional rise of almost 310% in less than a year and a half.
However, third, it is taking longer to bring the additional supply on-line to meet the projected new demand.
That demand, by the way, is also expected to spike in regions other than North America and Europe. Yet the pricing impact will be felt in New York and London – since West Texas Intermediate (WTI) and dated Brent crude benchmarks are still the bellwether indicators for international trade, despite accounting for only about 15% of the actual global oil trades on any given day. WTI and Brent are lighter and sweeter – having lower sulfur content – than most of what is actually traded in the market.
But that, too, is changing.
At the beginning of this year, I told you that more of this trade will move into a sour – that is, higher sulfur content – benchmark acting as the price determiner (see “The New Oil Index is About to Create Even More Opportunity for Investors,” January 12th, 2010). This is the Argus Sour Crude Index (ASCI) rate, set in London and providing greater leverage for euro-based transactions.
The transition to the ASCI will increase the price of oil in Europe under the current conditions.
However, as the Irish crisis abates – and it will – the net effect will be to raise the dollar-denominated price per barrel of crude trading everywhere.
Nothing happening in the European credit markets will change the overall, longer-term direction of oil prices…