Oil Market Resolution for 2009

Oil prices below $50 a barrel is an anomaly and defies the fundamentals. OPEC will soon trim its quotes by 2 -2.5 million barrels a day, reaching a cumulative cut of 4-4.5 million barrels since last September. OPEC countries will adhere to about two thirds of the total cut. It most likley need to cut again in February to correct the gap between the announced cut and the actual reduction. Putin will also give a helping hand to OPEC’s cut. The cost of marginal oil well in deep water is $70 a barrel and oil sand extraction in Canada requires a price near $50, otherwise the oil market is digging a deep trap for the future. All those factors are part of the oil fundamentals. We believe oil price should be above $50 a barrel and should target $70 near the end of 2009. The credit, stock, foreign exchange and commodity markets and maybe the economy are setting the stage for the oil price to bounce in the range of $50-$70 in 2009. This is the oil market’s resolution for 2009.

Political and economic factors are pointing towards a drop in credit risk and an increase in risk appetite by the end of the first half of 2009. By then, there will be a resolution of the big Three predicament, the TARP effect will start working, the new administration should start functioning and earnings expectations should start turning the corner. The increasing risk appetite process will be facilitated by credit expansion of consumer and commercial loans, and mortgages in the United States. Thus, the credit market will be on the oil side in 2009.

The increase in risk appetite will generate a movement from low yielding dollar- denominated assets to higher yielded assets dominated in non dollar currencies. This should be the result of a fall in risk aversion and the reduction in the usefulness of the dollar as the safe harbor at times of heightened risk. The volatility and fear index, the VIX, fell precipitously from a record of 90 to about 50. The comeback of the commercial paper has led to more than 50 percent fall in LIBOR between October and now. The aggressive US monetary policy is also going against the dollar. The net effect of the overall drop in risk aversion should help exert downward pressure on the dollar, and consequently shore up oil prices. The inverse relationship between the dollar and the oil price has been documented and justified. The dollar in 2009 should also be on the oil side.

The lowering risk and increasing risk appetite process should also be accompanied or preceded by improving stock market. This market is currently groping for the final bottom as it keeps testing previous bottoms. The market has not yet reached the final bottom as evident by results of the fourth quarter survey of corporate CFOs, Tobin’s Q and the cyclically adjusted price to earning ratio. The CFO survey shows that US CFOs are still very gloomy about corporate earnings in the fourth quarter. Tobin’s Q, which is the ratio of market value over replacement value, is about 0.7 for the S&P 500, implying that the stocks are undervalued. The range of this ratio for U.S. stocks is 0.3-2.9. It achieved the maximum value in 1999 and the minimum level in deep recessions such as the 1982-83 recession. This ratio has thus more way to go down to reach the bottom, compared to the deepest recessions since the Great Depression. The stock market will search for a bottom in the first quarter of 2009. It should first test the lowest bottom it touched in November. But since stocks are forward-looking and precede economic recoveries six to nine months and that many economists and financial analysts forecast an end to recession by the end of 2009 or beginning 2010, then we should see the stock market hitting a bottom roughly in March or June 2009 or in between. When this happens, the stock market will push the oil market up and oil prices will move and stay above $50 a barrel. The oil market should gallop behind the stock market. Thus, the stock market will be on the side of the oil market in 2009.

Gold getting wet by all the liquidity coming out from the world’s central banks is sensing inflation in 2010-2012. It keeps trying to stage a rally. Research has shown that gold price precedes oil price. Therefore, oil market should expect help from commodity markets in 2009.

Given all the above help, OPEC in its forthcoming meeting on December 17^th is in a better shape than in its last October meeting to help the oil market realize its resolution for 2009. But will OPEC do that?

Shawkat Hammoudeh is professor of economics and international business at Drexel University. Previously, he worked for Organization of Arab Petroleum Exporting Countries (OAPEC).