Why A US Debt Default Could Push Oil Above $130

Investors -- certainly U.S. stock investors -- would be wise to keep one eye on the goings-on in Washington between congressional Democrats, Republicans and President Barack Obama, and one eye on the price of oil, West Texas Intermediate of which Friday closed down 22 cents to $102.81 per barrel.

The reason? A downgrade of the U.S. government’s credit rating – let alone a market- and economy-jarring debt default – would likely lead to a weaker dollar, higher oil prices and yet another rise in already sky-high gasoline prices. Oil, priced in dollars, tends to move higher as the U.S. dollar falls, and vice-versa. It’s a result of oil traders trying to maintain their “purchasing power” in the event of a weaker dollar

What’s more, if Democrats and Republicans can’t reach a debt deal and the U.S. government defaults on its debt in about three weeks – a far worse scenario than a credit downgrade - the dollar may decline substantially, boosting oil’s price even more, perhaps above $130 per barrel for West Texas Intermediate crude.

So far in the financial crisis era, the dollar has held its own versus the euro, trading at $1.35, at $1.60 versus the British pound, and at 98.24 versus Japan’s yen, although Japan’s monetary easing in 2013 has been a major factor in supporting the buck versus that major currency.

However, if the U.S. Treasury has to postpone certain payments in three weeks because it legally can not borrow money because the debt ceiling isn’t raised, investors would likely drive the dollar lower against the world’s other, major currencies, and in the process send oil prices much higher.

How low could the dollar go? Different stress tests real different weaker-dollar scenarios. What’s important is that a 10% decline in the dollar would probably push oil above $120.

Oil: Approaching The 'Danger Zone'

Further, the reason why one should keep an eye on oil is obvious enough: oil is in "the danger zone," from a U.S. GDP growth standpoint.

No one knows precisely at what point oil begins to substantially hinder consumer spending and slow commercial activity – but this much is known: every $1 per barrel rise in oil decreases U.S. GDP by about $100 billion per year and every 1 cent increase in gasoline decreases U.S. consumer disposable income by about $600 million per year.

To be sure, the flexible and resilient U.S. economy is more-energy efficient today that it was 10 years ago – even five years ago -- and it will likely become even more efficient in the years ahead, but that doesn’t blot-out the fact that the U.S. remains an oil-dependent economy. Despite the increased use of hybrids, natural gas cars, and electric vehicles, most cars in the U.S. still run on gasoline, trucks on diesel, and oil is also a major fuel for heat. (Natural gas conversion from oil for heating and industrial use is accelerating, due to natural gas’s comparatively cheaper price, and this trend is likely to continue, but at least for the next 5-7 years, and probably for the longer, the U.S. economy will remain oil-vulnerable.) Hence, sustained, high oil prices translate in to bad things for U.S. GDP, corporate earnings growth, and by extension, for most U.S. stocks.

Further, psychological levels and outlook are important factors in the oil-GDP equation.

If the average U.S. price of gasoline, currently about $3.43 per gallon for regular unleaded as measured by gasbuddy.com, rises and stays above $4 per gallon, that would cause consumers to forecast that ‘higher gasoline prices here to stay,’ and they’ll likely adjust their discretionary spending. Similarly, an oil price that rises and stays above $100 per barrel has a similar psychological effect.

Pump Price Jump Scenarios

Now here’s the sobering news: there are scenarios that could push U.S. gasoline prices above $5 per gallon:

a) a U.S. government default that causes institutional investors to dump U.S. government bonds, causing a plunge in the dollar, pushing up oil’s price to beyond-the-stratosphere levels.

b) Any sustained unrest in another oil producing nation in the Middle East: Libya, Syria, Egypt and Iraq remain flashpoints of concern, due to their oil production, proximity to key oil transportation zones (Suez Canal), or potential to spark regional instability.

c) Stronger growth in Asia/Latin America emerging market economies, most of which are still registering large, annual percentage increases in oil consumption, despite oil’s triple-digit price.

Economic/Investment Analysis: Again, the U.S. economy can still grow with oil at $100 per barrel and gasoline at about $3.50 per gallon, but the chance for strong GDP growth above 4% with those energy prices is slim. Further, if Brent oil ventures toward $120, then $130, with gasoline trending toward $4.00 per gallon, oil enters the danger zone – compelling wide-spread consumer and commercial cutbacks.

Why is oil at $100 per barrel, despite sub-par U.S. GDP growth? Much of oil’s price rise in this decade can be attributed to institutional investors (IIs), who are piling into oil as both an inflation hedge, and a hedge against a possible weaker dollar. However, oil is also being boosted by adequate GDP growth in emerging markets – where the largest increases in demand this decade are and will probably continue to occur – and by a “geopolitical risk premium” (GRP).

The GRP is the bidding-up of oil prices by institutional investors, due to the threat of oil supply disruption, due to Middle East conflict and/or social unrest in other oil producing nations. (Such as Nigeria.)

But the inflation hedge / dollar hedge is the biggest factor in oil prices, short-term, and that speaks to goings-on in Washington. A failure by Democrats and Republicans to pass a budget, let alone a debt default, would, at minimum, lead to a credit downgrade – and that would hurt the dollar, driving up oil prices substantially. And as noted, any increase in oil prices is bad news for the U.S. economy, consumer spending, corporate earnings, and by extension, for U.S. stocks.

Hence, it goes without saying that investors -- certainly U.S. stock investors – should keep one eye on the goings-on in Washington between congressional Democrats, Republicans and President Barack Obama, and another on the price of oil.

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Disclosure: Lazzaro has no positions in stocks, or oil/energy futures, but does own U.S. Treasuries, corporate bonds and real estate.