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The Energy Revolution Intensifies

This latest rise in energy prices will have at least three distinct impacts. First, the stock market will see new leadership from the oil and energy sector. Oil and energy indexes and ETFs will gain in popularity with institutional and retail investors alike.

Second, rising oil prices are going to have knock-on effects in the world's currency markets. Oil, of course, is priced in dollars. And as it rises, governments around the world will have to decide how to handle the double whammy of rising oil prices and a falling dollar.

Already, governments in Russia, Japan, and South Korea have decided to "diversify" by owning fewer dollars and more euros. You'll see more dollar diversification as governments hedge their dollars (and rising oil price risk). This will also have an effect on U.S. interest rates.

Third, rising energy prices are going to intensify the great game of geopolitical chess that's unfolding before our eyes. There are many players in the game, but the key ones are Iran, Russia, China, and the United States.

Wall Street does not believe in $40 oil. But prices shouldn't have anything to do with belief. There is a deep institutional skepticism that oil is now priced "petro-politically," or that the political premium in oil means the base price for crude is now $40, not $25-30.

Saudi oil minister Ali Naimi - at the mid-March OPEC meeting in Tehran - said the Kingdom thinks oil should trade between $40-$50 per barrel, in order to ensure steady global growth. He also said he thinks that oil at $55 per barrel is "too high."

There are lots of people on Wall Street who agree with him. You wonder if these oil skeptics have a basic grasp of supply and demand. First of all, in real terms, oil is still trading well below what it was during the oil shocks of 1970s.

Oil is still cheap! It would have to rise to $80 in today's dollars to reach its past highs. In other words, the big bull move in oil - even after a doubling in crude futures in the last year - may not have even started yet.

And why is that the case? Supply and demand. In its constant quest to turn news into an explanation for price movements, Wall Street pays religious attention to the forecasts of the International Energy Agency and the inventory figures produced by the American Petroleum Institute. But seasonal or monthly fluctuations in oil inventories or demand don't begin to give you the fundamental picture.

The fundamental picture is very simple, almost childishly so. Demand is increasing; supply is not. That's it. No hidden logic. No secret turn of events. More people are competing for the same scarce energy than ever before. If anyone tries to tell you that oil ought to be at $25 and that this is a bubble top, ask them what recent forecast showed an increase in the world's oil supply. Don't be surprised if they look at you like you have three eyes. No such forecast exists.

There are other factors affecting the oil price. The dollar is one. But a long-term increase in demand is the biggest one. The demand for oil is leading commodities to take over as the asset class of choice for the world's investors. Since stock markets peaked in 2000, the Dow Jones AIG Commodity Index has absolutely outperformed the S&P 500.

The Dow remains the most difficult of the three to forecast. Economically, high oil runs the risk of slowing economic growth and damaging corporate earnings, which is generally bearish for stocks. Obviously, the entire energy complex (shippers, refiners, explorers, major integrated stocks) is the exception to the rule.

There is also the possibility (or even likelihood) that oil's climb to 1970s levels will be a stair-stepping process, ascending in big gaps and pausing to collect itself. This gives the Dow and other major indexes a chance to "price in" the move. Big daily changes in the Dow are less likely in this scenario.

But we can't really forecast the Dow without factoring in volatility. Volatility - as measured by the VIX - has been so low for so long that nearly everyone expects it to increase soon. It's one of the market's strange ironies that low readings on the VIX do not actually mean the market is stable, but that pressure is building for a big move. But which way? Will increased volatility on the VIX be bullish or bearish for the Dow?

The answer is "bearish," but for traders, the Dow isn't the index to watch when the VIX rises. Individual Dow components will react differently to a rising VIX. But in general, rising volatility means a decline in speculation.

What about bonds? If the early price action is any indication, high oil is bullish for bonds. In my speech at Investment University in Delray Beach, Fla., I said that higher oil prices would force investors to choose between emerging markets and U.S. bonds. Up till now, investors have had the leisure of chasing higher yields in emerging markets without the worry that oil prices would hit less-developed economies hard. Not anymore.

The net effect - again based on the early trading patterns - is that investors are selling emerging markets and buying (gulp!) U.S. Treasury bonds. This is the classic "flight to safety" move we've seen in the past. Selling emerging markets because of rising oil prices makes sense to me. Buying U.S. bonds as a measure of safety does not.

As one reader pointed out to me at Delray Beach, however, good investors do not confuse what should happen with what is happening. You can outsmart yourself by coming up with too many reasons why investors should not buy U.S. bonds. And just for grins, I can think of three of them right off the top of my head: $59 billion, $113 billion, and $666 billion.

Fifty-nine billion dollars was the February trade deficit. Americans continue to consume more than they produce. The last I checked, this was still NOT a way to get rich. The next number, $113 billion, was the federal government's February deficit. The Great Fiscal Father in Washington continues to set a bad example to a nation of fiscal children by spending more than he takes in. This, too, should be bond bearish. Yet it isn't.

Finally, the diabolical last number, $666 billion. That was America's current account deficit for 2004. It was a 24% increase from the year before. It now amounts to 5.7% of GDP. But those are just numbers.

Let me put it in plain terms for you: America is increasingly dependent on foreign central banks to sustain the value of the dollar. High consumption is made possible courtesy of the world's savers. We are getting a free ride into indebted servitude to foreign bondholders. The ride into indebtedness may be free, but getting out is going to be very expensive.

That trifecta of debt ought to be enough to scare the daylights out of U.S. Treasury bondholders. But in the context of high oil prices, the debt numbers take second place in investors' minds - at least for now. U.S. bonds are getting a bid.

Fundamentally, the stage is set for a huge dollar sell-off. With the deficits soaring, demand for the dollar is bound to wane. When it does, the dollar will go down, interest rates will go up, and a whole series of secondary reactions will unfold in the markets.


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