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The Oil Narrative is Decidedly Bearish, Believing Prices are Not Sustainable.

Oil is over $60 barrel, the highest level since December and up about 40% since it mid-March six year low.  The reasons for yesterday’s gain…Libyan port closure and an increase in price that Saudi Arabia charges some North American and European customers.

The oil narrative is decidedly bearish, believing prices are not sustainable.

I will argue this lack of conviction is the result that few had thought oil would fall from $100 in six months.  In fact as recently as early November 2014 with oil around $80/barrel, consensus thought crude would be around $95 barrel in 2015,   Oil bottomed around $45/barrel on March 18.

I have consistently argued oil prices should be in the $75-$85 range for two simplistic reasons.  First is the threat of supply disruption given Middle East anarchy.  Second, there is no interest like self-interest.

Several months ago I was writing about severe budget issues of many Middle Eastern countries.

It was reported Saudi Arabia spent $36 billion of its central bank’s net foreign assets—about 5% of the total–in February and March, the biggest two month drop on record.   A reason for this sharp drop, to ensure domestic tranquility, the kingdom gave its government employees and pensioners a two month bonus.

Saudi Arabia expects oil to stabilize between $70 and $80 leading into 2015.  If oil stabilizes around these levels, its budget gap is expected to widen to 14.5% to 17% of GDP, compared to a 1.9% gap in 2014.

In my view, if oil stabilized at the above level of $70 to $80 there has to be some cut back on social programs.  However will any cutbacks increase the probability of social unrest given that 44% of its population under 29 in unemployed according to Saudi statistics?

And then there is the widening war in Yemen.

Yesterday the IMF warned Middle Eastern oil exporters must take “swift steps” to balance the impact of falling crude, steps that include reducing fiscal spending and social programs.

The IMF is now projecting the block of six nations that comprise the Gulf Cooperation Council which Saudi Arabia is the defacto head, will have a 2015 budget deficit of $113 billion or about 8% of GDP versus a $76 billion surplus in 2014.

I ask three questions.  Will OPEC reduce production at its June meeting?  Or will anarchy increase given a potential cutback on social programs that raises the odds of a supply disruption?  Or will desperate non state actors take dramatic steps to increase prices via radical action hindering supplies?

All of the above are possible.

Yesterday’s continuing gains in oil impacted the fixed income market as some now believe the rise in oil prices will be inflationary.  The 10-year has been crushed almost 30 basis points in seven trading days.

Wow!  That is ugly but is this not an objective of all Central Banks—increase inflation?

Last night the foreign markets were up.  London was up 0.25%, Paris up 0.68% and Frankfurt up 0.99%.  Japan was up 0.06% and Hang Sang down 0.41%.

The Dow should open flat.  Oil prices are again higher on the belief that the glut has stabilized. The European bond market has also stabilized.  And then there is Greece.  To date Greece has impacted the averages.  I hope this complacency is not misplaced.  The 10-year is off 4/32 to yield 2.20%.

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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.