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Weekly Market Intelligence | 2.28.2011

Taken from iSharesblog.com

This week political issues in two different parts of the world hold investors’ attention as we keep an eye on rising oil prices and wait for a solution to Europe’s sovereign debt problems.

First, the energy markets: crude oil hit a 2 ½ year high last week.  Given that political unrest in the Middle East is unlikely to dissipate quickly, one would expect crude prices to remain elevated.  Crude is also likely to have a larger than normal geopolitical risk premium built in during the coming weeks, making it trade above where it would otherwise trade based on spare capacity and inventories.

Libya plays a significant role.  First, Libya’s crude production is 1.8M barrels per day (BPD) – 3X the amount that Egypt produces.  Second, Libya contains 40M barrels of proven reserves, about 3% of global supply.  And third, unlike Egypt where a strong military appears capable of safeguarding both production and transit (in the Suez Canal), Libya is descending into a civil war, where production has already been impacted (down 500K to 1M BPD as major oil companies pull out).

Bottom line – the loss of all or part of Libya’s production coupled with an increased risk premium will likely keep oil prices elevated.

Moving on to Europe, domestic politics in Germany and Ireland will complicate and delay a more permanent resolution to Europe’s sovereign debt problems, which could represent a marginal negative for European regional banks.

On March 17th – one week before the European summit – German parliament is likely to pass proposals that would rule out the European Stabilization Mechanism (ESM) and European Financial Stability Facility (EFSF) – the mechanisms established to deal with European sovereign debt issues by buying government bonds directly or issuing loans to help governments buy back their own debt.  This move is designed to harden German negotiating positions ahead of the EU summit and will make a permanent compromise solution to Europe’s debt problems more difficult.

Adding to the political friction, in Ireland the Fine Gael party is poised to unseat the ruling Fianna Fail party at the February 25th election.  Fine Gael is almost guaranteed to push back on the previously agreed-upon deal between Ireland and the IMF/EU.  In effect, the party will argue for a lower interest rate on the bailout package and a haircut for bondholders – who are largely European banks.

Essentially, Europe’s creditor – Germany – and one of Europe’s biggest debtors – Ireland – are both hardening their negotiating positions.  While unlikely to blow up (a muddle-through compromise is expected at the summit), European sovereign debt issues will linger and the risk of a haircut for bondholders is a bit higher.

 

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