Thursday, April 15, 2010

Phil Flynn: Forget those Fed Fund Futures, Oil is the key!

Ben Bernanke spoke yesterday and the oil market listened. Of course listening to Ben Bernanke and his comment about the price of oil made one wonder whether or not Big Ben gave traders the green light to buy oil. Among other things that the Fed Chairman said about the economy was that the current price of oil was not a threat to the economy. "At this point oil prices are not a serious threat to the recovery," Bernanke told a Congressional Committee. "Clearly if it moves a lot it would be a negative, so we have to watch it."

Of course they have to watch it. If oil prices spin out of control it could endanger an economic recovery which begs the question, at what point does Bernanke see oil prices as a threat? Obviously that is a difficult question as the price of oil can move higher comfortably as long as it accompanies strong economic growth. With Mr. Bernanke basking in the light of some strong data and earnings, it seems the oil price right now is a concern but not a major one. My guess is that Mr. Bernanke’s point of pain on oil is $90 for the rest of the year. That means that instead of watching Fed fund futures for an estimate of when interest rates will raise, perhaps we'd do better to watch the crude oil curve.

If we see oil go solidly above $90 a barrel then perhaps that would be the month we would expect a rate increase. Which means according to the oil market price with the December contract trading currently at 8990, there is an approximate 98 percent chance the Fed will raise rates in December and with January at 9006 over a 100% chance they will increase early next year? If the front month oil contract goes solidly over $90, the pressure on the Fed would be enormous to try to do something despite the subdued core inflation rate.

China is hot, hot, hot. So hot that it's getting too hot for the Chinese government to handle? China's GDP came in at a three year high blistering rate of 11.9% raising fear this morning that China is going to have to do something dramatic to try to slow things down. At the same time Chinese consumer prices climbed 2.4 percent in March which was less than expected. Yet at the same time this is a number that is fraught with danger for the future of the Chinese government. Those fears about China may be one reason the oil market seems less than impressed with China’s strong GDP or perhaps the market feels that yesterday move up in oil basically priced strong China growth in.

How much of the Iranian threat is priced in. Some traders took note of the story about Iran’s capability to shutdown the critical oil export choke point the Straits of Hormuz. Bloomberg News reported, “Iran’s build-up of its defenses gives it the capability to block a major Persian Gulf oil- transit route and project military strength on its territory, the U.S. Defense Department’s intelligence director said. “It does have the ability to restrict access to the Straits of Hormuz with its naval forces temporarily and threaten U.S. forces with missiles,” U.S. Army Lieutenant General Ronald Burgess, director of the Defense Intelligence Agency, told the Senate Armed Services Committee. Iran has taken steps to strengthen its military defenses and cultivate allied terrorist groups targeting the U.S. and Israel, Burgess told the committee. “Iran can conduct limited offensive operations with its strategic ballistic missile program and naval forces,” Burgess said.

Iran has threatened to block the Straits of Hormuz before. The EIA says that narrow Straits of Hormuz between Iran and Oman (21 miles width at its widest point) is the most important choke point for oil shipments from the Persian Gulf. Roughly 17 million barrels per day, more than 20% of the world’s total oil supply, transit this route. If the Straits of Hormuz were blocked, only a small share of the oil could be transported along alternative routes. The most viable is a 745-mile long east-west pipeline through Saudi Arabia to the Red Sea. The possibility that Iran might try to close these straits would cause the mother of all oil spikes but at the same time it would also be the end of the Iranian regime as we know it. The global outrage from such a move would be met with swift and lethal resistance.

Oil also got a boost yesterday on the EIA which showed a surprisingly large crude draw on the East Coast. I suspect that that number will be adjusted somewhat next week to the upside but that does not help us this week. The EIA said that crude oil inventories decreased by 2.2 million barrels from the previous week. At 354.0 million barrels, U.S. crude oil inventories are above the upper limit of the average range for this time of year. Total motor gasoline inventories decreased by 1.1 million barrels last week, and are above the upper limit of the average range.

Phil Flynn can be reached at And make sure to watch him every day on the Fox Business Network!

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