$700 Billion Banking Bailout Will Drive Crude Oil to $250

By: Money_Morning

Keith Fitz-Gerald writes: I've been predicting record oil prices for a number of years now, so when crude oil prices recently plunged from their record highs, I warned investors and consumers that the decline was nothing more than a temporary respite.

But now it's clear that the fallout from the $700 billion banking bailout pact will virtually guarantee that my prediction will come true.

As the curtain closed on the third quarter yesterday (Tuesday) - leaving many investors worried that the long-feared "Super Crash" was imminent - crude-oil futures were staring at their first decline in seven quarters and their biggest quarterly decline in 17 years, thanks to worries that a slowing economy would curtail global demand. As of early afternoon yesterday, crude oil for November delivery had dropped $39.36 a barrel - or 28% - during the third quarter to close at $100.64 yesterday afternoon.

It's been a volatile market, too. Oil traded within a $56 range in the quarter , reaching a record $147.27 a barrel on July 11 and retreating to as low as $90.51 a barrel on Sept. 16, Bloomberg News reported. Oil futures moved 5% or more during one quarter of the trading days.

Analysts said this decline was merely the beginning, and that with a global economy that had been severely singed by the U.S. credit crisis, oil prices had nowhere to go but down.

But I continued to make the opposite argument. And a week ago, the markets made my point for me. On Sept. 22, crude oil futures for October delivery soared $16.37 a barrel, or 15.7%, to close at $120.92, after trading as high as $130 a barrel - thanks to a steep decline in the U.S. dollar and to speculation that the Bush administration's plan to bail out the financial sector might actually jump-start the U.S. economy, fueling inflation in the process. The gain surpassed the previous record single-day-price gain of $10.75 a barrel, a move that occurred on June 6. [The biggest-ever percentage gain in a single day - 20.9% - was recorded on Jan. 3, 1994, according to FactSet Research Systems Inc. ]

This record one-day surge caught many by surprise and jump-started speculation about whether oil prices will rise or fall from here.

For you disciples of doubting Thomas out there, you only have to look at the reaction to the different phases of the bailout negotiations this week to see that the market has spoken again. Crude oil for November delivery dropped $10.52 a barrel, or 9.8%, to close at $96.37 on Monday after the House of Representatives rejected a Bush administration bailout plan. But that was a knee-jerk reaction to a worry that the lack of a bailout pact might spawn a recession.

Yesterday, however, crude oil futures rebounded $4.27 a barrel, or 4.4%, after analysts realized, upon reflection, that the U.S. economy - together with the global demand for oil - wasn't about to just disappear. And that was without the benefit of even a bailout proposal. When a pact is signed - as most analysts figure it will be - crude prices will likely rebound even more.

The Outlook for "Black Gold"

In the extreme short term, oil's probably going to bounce around the psychologically important $100-a-barrel mark, - if not a little higher - as the U.S. government works to sort out the financial crisis.

The reason is that any "recovery," or bailout is intended to strengthen the flagging U.S. dollar. And a rising dollar tends to push crude prices lower because crude is traded mostly in U.S. dollars around the world.

So, as much as most of the world looks to Organization of the Petroleum Exporting Countries (OPEC) to determine the price of oil, the more important influencers in the near term actually are U.S. Federal Reserve Chairman Ben S. Bernanke and U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. - the Batman (Bernanke) and the Boy Wonder (Paulson) of Washington's bailout set.

The $700 billion banking bailout package proposed by this "Dynamic Duo" directly impacts the flagging U.S. dollar. And the dollar, for reasons we've just explained, helps determine oil prices.

There are exceptions, of course, but the relationship between currencies and oil prices generally suggests that 90% or more of the decline in price that crude oil has experienced since mid-summer can be accounted for simply by how much the dollar has risen since July.

But here's the trick - the reverse is also true.

We mentioned inflationary pressures before. Well, if Congress actually passes the bailout plan, another $700 billion would be pumped into the world financial system. And that would mean far higher prices are ahead. We're talking Econ 101 here: Every one of the bailout bucks dilutes the buying power of every other dollar already in circulation. That erosion in buying power is the textbook definition of inflation.

In fact, that's just how it played out this week. When the bailout plan was rejected Monday, meaning those bailout bucks wouldn't be joining the financial system, oil prices fell precipitously, since there would be no additional inflationary pressures. But when investors started to rethink that thesis Tuesday - meaning they believed some sort of new bargain would be reached - oil prices reversed course and rose in anticipation of that money possibly being pumped into the financial system.

While a bailout could jump-start the financial markets for a while, history suggests that over time the "cost" of the liquidity Bernanke and Paulson have cobbled together may manifest itself in the form of far higher oil prices. Other commodities would rise significantly, too. Investors have only started to see this outcome.

So, what happened back on that Monday, Sept. 22, when oil prices made that record one-day run?

My experience as a professional trader makes me think that somebody simply got trapped on the wrong side of the markets and was trying to cover a humongous position at any cost.

And what I saw on my screens seems to confirm that. It was a late-session spike at a time when traders either had to get in line for delivery or unwind their positions before the October crude futures contracts expired. With a mere 30 minutes remaining, there were no sellers to balance prices, while the market makers who normally would provide a modicum of orderly behavior were nowhere to be found amidst the chaos.

Five Points to Bank On

What's likely to happen longer term? Simple. In fact, here are five points you can take to the bank.

• First, global oil demand is still accelerating and, according to the United States Energy Information Administration (EIA), will reach more than 115 million barrels per day by 2030 - even with conservation efforts and high prices stunting demand.

• Second, daily production has probably peaked right now at nearly 90 million barrels a day, or will peak in a few years at the very latest. While experts once debated the reality of the " Peak Oil " concept, they now accept it and only question when it will take hold.

• Third, the world's fastest growing economies, China and India , are still increasing consumption at double-digit rates, and that more than offsets any conservation efforts that are under way elsewhere around the world. And their governments want to buy oil at any cost - even if that means there's none left for us.

• Fourth, the world will learn one day - probably sooner rather than later - that Saudi Arabia's vaunted reserves are nowhere near what it claims them to be, and those reserves are certainly not at the levels long held as "gospel" in the oil business. Matthew Simmons , chairman of the Houston-based investment bank Simmons & Co. International and author of the seminal 2005 book, "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy," has been most vocal about this alleged shortfall, and I respect his work, especially since I've spoken behind closed doors with several OPEC figures who privately acknowledged that this may be their worst nightmare. Simmons recently predicted that oil prices would rally to $500 a barrel .

• Fifth, Bailout Ben has dropped trillions into the system to stabilize the Wall Street while Paulson has broken out his bazooka which suggests that as much of 95% or more of oil's price drop can be attributed to nothing more than the dollar's rise since July. Nothing else has changed.

Should traders see through the smoke and mirrors or simply decide to run for the exits, we can expect to see the dollar shrink to new lows and oil to rise to new highs in a perverse flight to quality.

Only this time, this "quality" is literally quite crude …

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News and Related Story Notes:

• Money Morning News Analysis : Crude Oil Futures Post Record Gain as "Peak Oil" Expert Calls for Rally to $500 a Barrel .
• Bloomberg News : Oil Plunges Most in 17 Years in Third Quarter on Economic Woes .
• Wikipedia : Organization of the Petroleum Exporting Countries .
• Wikipedia : Energy Information Administration .
• Money Morning Special Investment Research Report: Special Report: Hit the BRICs for a Global-Investing Double Play (Part I - Brazil and Russia).
• Money Morning Special Investment Research Report: Special Report: Hit the BRICs for a Global-Investing Double Play (Part II - India and China) .
• Wikipedia : Peak Oil .
• Money Morning Market Analysis : Crude Oil Futures Post Record Gain as "Peak Oil" Expert Calls for Rally to $500 a Barrel .
• Money Morning Special Investment Research Report : Money Morning Boosts Oil Target Price to $225 a Barrel, Thanks to Continued Scarcity, Burgeoning Demand in China .

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