Sean Maher's  Instablog

Back on December 10th, when many momentum chasing oil analysts were forecasting $25 crude, I wrote here on Seeking Alpha that: 'While demand destruction will cap upside to maybe $80 through 2009, the collapse in desperately needed investment spending, as production in key exporters like Mexico collapses, is setting us up for an inflationary surge in energy prices when the world economy inevitably recovers post 2010. Long term production exposure via oil majors and second-tier exploration plays with proven reserves is now very attractively priced (although oil service stocks will be impacted by slumping E&P spend).' That proved a prescient call, and the oil price is now back at levels above $65 seen in late 2006/early 2007 amid a global economic boom, and just before the explosive speculative surge that peaked in Summer 2008. At the time, I identified the move above $100 as fuelled by a Nasdaq style bubble driven by huge inflows into a very poorly regulated market, and one that would precipitate a global recession. The impact of soaring gas prices on already overleveraged US consumers is generally underestimated, and proved a critical tipping point that accelerated housing foreclosures and a retail spending slump, as discretionary income was squeezed.

In the last month, average US gas prices have jumped over 20% and are now approaching $2.50, despite ongoing demand destruction and ample global stocks of crude and products. Why? At $40 and below, crude was a steal, as that was barely above marginal cash production costs (and marginal costs of new offshore production are about $70) and the steep contango structure in the market encouraged not only OPEC quota compliance but also speculative arbitrage between spot and futures by storing oil in offshore tankers.

As a result, about 100m barrels is now floating in tankers awaiting a home (at a storage cost of $1/barrel per month), while onshore storage tanks are also full to capacity (including both the Chinese and US strategic reserves). While the 2007/8 bull run was driven fundamentally by a narrowing cushion of daily supply over demand, there is no such constraint for the next couple of years. Essentially, the tidal wave of liquidity unleashed by Fed monetary policy is now washing through the commodity markets directly in driving speculation and rising inflation expectations and indirectly by undermining the dollar. As I forecast early this year, inflation expectations as reflected in the 10 year Treasury/TIPS spread are already back at 'normal' levels of near 2%, after the deflation panic earlier this year. It is quite possible we will see $75-80 oil by year end, on real evidence of a global economic recovery in 2010. Near term, the speculators who bought oil around $40 are looking at a 50% return in a few months after storage costs, and the temptation will be to bank it as the price curve has flattened considerably. That would blunt the pace of the current move. Otherwise, a move above $70 on pure technical momentum at this fragile point for the US economy would prove a major setback to recovery hopes, particularly in conjunction with mortgage rates heading above 5% again and mortgage refi activity reversing. While equity markets are being boosted overall by the oil surge thus far, that may soon change if it begins to kill some of those tender green shoots.