1. Oil price at $80? Possibility would lead to higher inflation, higher interest rates and a crash in equities

Oil price at $80? Possibility would lead to higher inflation, higher interest rates and a crash in equities

If oil prices were to rise sharply, it would come as a big surprise to the market, generating a sharp spike in volatility

By: | Published: October 20, 2016 6:22 AM

I was recently shocked to realise that I had quit smoking only about three years ago. We all tend to congratulate ourselves when we do something unequivocally good and so, in my imagination, I was sure I had quit “a long time ago”. I realised this a few days ago when I suddenly remembered buying single cigarettes from a small shop near my old office from a very sweet 13-year-old girl—Karishma, as I recall—who was running her Daddy’s shop when she got home from school. I had moved out of that office a little less than 3 years ago, which means that I had stopped smoking for just about that length of time. Anyway, the point of this reminiscence is to recall a fundamental lesson you learn as a smoker—if you are waiting for a bus and you light a cigarette, the bus will come immediately.

I thought about this lesson when I read that Saudi Arabia is set to launch its first international bond issue. This “…is part of a radical plan to wean the kingdom’s economy off its reliance on oil and was first announced in November 2015, as oil prices fell to $50 a barrel from $115 a barrel the previous year… Riyadh has reacted to the fall in oil prices by cutting government spending, burning through foreign reserves and raising debt to finance steep budget deficits that have not been seen since the 1990s.”

Just the previous day, I was looking at a chart of oil prices and was struck by what seemed like a perfectly formed—or, perhaps, forming is more accurate—reverse head-and-shoulders pattern, which suggests that if oil breaks even marginally above its current level of $52 a barrel, it could/will likely shoot substantially higher. The target, according to our technical analyst, would be over $80 a barrel.

Now, technical analysis is generally too arcane for me—in fact, like most people, I am usually able to “see” the pattern only after the fact. For instance, looking at a sterling chart (on Wednesday), I could clearly see a head-and-shoulders formed between December 2012 and August 2015, with the head around July 2014 at 1.71, which indicated a drop to 1.24 or so if it broke the neckline of 1.46. Sterling fell below 1.46 in January 2016, long before the Brexit vote. Of course, hindsight is 20/20.

Mulling these ideas, I got a call from one of the most successful investors I know, so I told him all of the above and asked him what he thought of oil. His comeback was wonderfully elegant. He said, “Most technical analysts live beyond Borivali, so…” And, he continued, with the number of US rigs increasing again and the obvious fact that all of the oil producers need to pump as much as they can to manage their budgets, he didn’t really see how oil could break out.

I pointed out that markets are, of course, smarter than all of us, and often do the least expected things, leading to sudden surges in market volatility. Right now, with the exception of sterling and the yen, volatilities of most currencies and commodities are lower than long-term averages, which, given the cyclical nature of volatility, suggests that they could turn up at any point in time, including now. Again, given the ongoing concerns about overvaluation of global equities and negative interest rates, such a sharp rise in volatility would hardly be surprising.
All that is missing is a trigger.

US interest rates are unlikely to provide this, since everybody and her brother are expecting rates to start rising, probably in December. While this will likely push the dollar higher, it is unlikely to create any real instability because most people expect this to happen. Donald Trump winning the US presidential election could have provided the trigger, since it would open up uncertainty on an unprecedented “I’m so great” scale; but, it seems more than clear that his grotesque adventure is deflating by the day. Hillary would be status quo for the market.
However, if oil prices were to rise sharply, it would come as a big surprise to the market, generating a sharp spike in volatility. In macro terms, it would certainly lead to immediately higher inflation expectations, higher interest rates and the long-awaited crash in global equities.

It would be poetic, indeed, if Saudi’s first global bond issue turned out to be the trigger for higher oil prices.

The author is CEO, Mecklai Financial

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