What the European Debt Accord Means For Oil
Yesterday's huge move up in the markets was an expression of relief, if nothing else.
After months of frustration, an accord is coming over the debt crisis in Europe. It will unfold along the lines I suggested.
But what does this mean for the oil sector?
First off, we need to understand what has actually happened. And that, as it turns out, is not easy. Much of the details in the debt package still need to be worked out.
Breaking the Stalemate
Removing the European Central Bank (ECB) from generating the leverage necessary to float the European Financial Stability Facility (EFSF) the bonds needed to refinance the debt set the stage for an underpinning of the beleaguered Euro. This brought Germany (reluctantly) into the fold.
The condition of France's banking sector will weigh most heavily. Bankers across Europe had been adamant in accepting no more than a 21% haircut (write-off of Greek debt and cross-border extensions of that debt). The health of French banks is paramount in that equation.
Early Thursday morning (about 2 am Brussels time), a calculated gamble by German Chancellor Angela Merkel and French President Nicolas Sarkozy broke the stalemate.
They forced the banks to accept a 50% reduction or bear the responsibility for a collapse in the continental currency.
The 50% level may still not be enough to prevent what is delicately called “selective defaults.” When all is said and done, peripheral economies like Greece may still be thrown under the bus.
The EFSF is now leveraged to the tune of one trillion euros. This sounds impressive, but is not likely to meet the real need.
For example, it cannot be applied to Italy – the screaming child now becoming the focus of attention – where the debt encumbrance is simply too large.
Still unknown are a number of ingredients, two in particular.
The Missing Ingredients
Who is going to buy this paper? And how will the European banking sector be recapitalized?
Both are essential or the plan will fall flat on its face. Unless the banks retire held debt and purchase the new re-leveraged bonds, this initiative will implode.
Nonetheless, we have something we did not have Wednesday evening – a road map. That was enough to spark a global market rally, even without the blank spaces filled in.
How long that lasts is another matter. Once the initial rally had already set in, much of the movement yesterday in the U.S. markets were actually traders covering shorts.
Remember, most major European markets had outright banned or otherwise impeded traders from shorting weak local banks. But traders accomplished the same by shorting stock in New York.
The Impact on Oil
The impact on oil, however, is direct and significant.
First, as we moved from the non-event in Brussels on Sunday to the watershed accord early yesterday morning, crude was responding to the likely resolution. NYMEX West Texas Intermediate (WTI) benchmark prices increased 10% for the week, while Brent in London also went up, but only 3% during the same period,
The spread between the two is now narrower than it has been for months, coming in at barely 20% of the NYMEX price level. I have mentioned several times that, when this spread starts declining, WTI will be increasing rather than Brent moving down.
There is a simple reason for this. In a market that is reflecting the actual dynamics of oil, rather than external matters such as debt or a Libyan civil war, WTI should be priced higher than Brent, as was the traditional situation prior to Mid-August of 2010. That is because it is a better quality crude.
That translates into higher profits across the board for virtually every element in the U.S. oil sector.
Second, we will again see the rise in the euro against the dollar, a development that was witnessed yesterday. As the pressure on the European currency declines (at least in the short to mid-term) it will appreciate in value versus the dollar. Since virtually all crude oil sales internationally are denominated in dollars, it will take more dollars to buy the same amount of oil.
That means the price is going up.
Third, demand is already up globally (although it has been subdued in the U.S. and Europe, these markets no longer comprise the primary sources of demand). The appearance of a resolution in the debt crisis will spark additional usage in regions well beyond the continent.
Additional demand will call into question readily available supply. That, in turn, will oblige increasing reliance on more expensive to produce and process volume.
And another increase in price…
Finally, the price of oil has been suppressed because of concerns over another recession, stagnant development here and in Europe, concerns over the availability of credit, and similar depressions of economic expansion.
Much of this has been reaction to anecdotal data or an over reliance on identifying connections where there actually are none. (Remember, economists are the fellows who have predicted six of the last two recessions).
It is this psychological view of another decline that is likely to be the primary casualty of the debt accord breakthrough, assuming, of course, the details can be worked out.
That, in turn, will oblige a reassessment of unjustifiably pessimistic forecasts of oil usage.
And the price will go up.
Any way we look at it, seems like we are off to the races.