Expect governments to start fighting oil if it goes much higher

We would expect governments to actively fight oil if it goes higher in the coming days. There is a widespread belief among government officials that oil prices above $85 or $90 barrel are bad for the economy and likely to stall the still fragile recovery. Officials believe that there is a threshold level (somewhere between $80 and $100 per barrel) where the effects of higher prices become much worse. There is some empirical evidence to support this (See recent papers by James Hamilton) and I would expect spending on consumer durables to slow sharply if oil prices break $100 for any sustained period. Gasoline prices have started to move up and, while no where near their highs of 2008, are now above their highs for 2009.

The mainstream media has latched onto this theme of "the recovery stalls if oil goes over $85" as evidenced by a flurry of articles that hit the media when oil breached $80 in October. I would expect another flurry of articles if oil goes higher from here especially if we get above $85. These articles will warn that higher oil prices "may threaten the recovery". From there I would expect more aggressive action if prices don't roll over. First we will hear of renewed commentary about restricting commodity traders, position limits, margin increases etc. If that fails, we may even hear rumors of an SPR release if prices go higher. Even if the government has no intention of making an actual release, they can make traders nervous with rumors.

Most Importantly, the US government isn't the only government that worries about higher oil prices stalling the recovery. European, Asian and Middle Eastern governments share these concerns particularly Saudi Arabia. Saudi Arabia also has a history of working closely with the US government (as does Kuwait and the UAE). I would expect that any move higher will concern US officials enough that they will quietly (or maybe loudly) ask the Saudis to raise oil production. As the Saudis share the same fears about a stall in the recovery, I expect that will move to raise production and announce an increase in shipments to Asia once prices become a macroeconomic concern. This is exactly what happened in October. While the production increase may take 6 weeks to two months to hit the market, this announcement should be enough to halt upward price momentum.

In October we had a similar situation. Oil prices rallied rapidly from $66 to $82 in a matter of weeks. Once prices got above $80 they became a focus of media concern and presto we had the Saudis announce an increase in shipments to Asia. This was compounded by dumping from floating storage to capture relatively tight timespreads and oil stalled and then fell back into the 70's.

Now we are three months later and a couple of dollars higher in price but I would expect the same thing. Higher prices lead to media and official concern. Saudi Arabia and OPEC raise production and floating storage is unloaded at favorable timespreads. Prices should stall for a while and drop back to the 70's.

This process can go on as long as Saudi Arabia has spare capacity (according to them they have 4 million barrels, oil bulls would put the number closer to 500,000) and as long as there are large inventories floating at sea. Once the spare capacity and excess inventories are gone, things will get much more interesting.