Oil Would Collapse on Default

 | Oct 14, 2013 | 11:12 AM EDT
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I'd like to be writing today about the Hess (HES) asset sales and how its restructuring is increasing their relative exposure to its Bakken exploration, and how that's good.

I'd like to be writing about the relative move of RINs and the concurrent blowout of Brent/WTI spreads, the subsequent rally in almost all the refiners and whether this is a short-term or a longer-term move you could bank on going into 2014. 

I'd like to write about a whole host of things that have nothing to do with the stalemate that somehow continues in Washington and threatens to sabotage every other good piece of research or insight I could possibly give.

But I can't, so let's go there. Let's imagine the unthinkable. Let's talk about what happens to oil in the (still hopefully) unlikely case that we reach Thursday without a debt-ceiling deal. 

There's no one with any credibility anywhere who has tried to minimize the catastrophic effects of missing a bond payment on a Treasury and I won't be the first. I have no time for nonsense about payment prioritization or the amount of incoming revenue that could be diverted to servicing debt during a debt limit default.

None of that matters when it is really the faith of the credit is on the line.  Even if every payment were met, that would be destroyed, perhaps forever. 

It is that psychological damage that would have the greatest effect on oil prices. If you were looking for a silver lining in a Treasury default, here it is: oil prices would collapse. 

There are two competing factors into the oil market should we get to bond default. One side would have investors seeking oil (as they might gold) for a hard asset alternative to a shaky U.S. Treasury. But that positive would be entirely swamped out by the catastrophic failure that would take over the credit markets. 

That's because the oil market, as much as it might look like it is physically based, with real tangible supplies that loom behind it, is much more financially dependent than it seems. Indeed, more than eight times the amount of physical oil that exists is traded financially every single day. If we limited the trade in oil to those who actually use the stuff, we'd have very little business that needed to be done on the oil exchanges. 

And almost all of those financial players rely upon credit to keep their positions afloat. Even I can get close to 20-to-1 leverage on my positions in the oil market, and larger players have far better support.

To give (a small) example of the likely outcome of a debt default, look at the financial crisis of 2008. Oil dropped from a high of $147 a barrel to a low of under $40 while there was a prospect for a huge recession with subsequent production declines in 2009. A drop of that magnitude was far more attributable to the seizing of major credit markets that accompanied the stock market and other asset markets' collapse.

That's what would happen here, today, starting Thursday, to perhaps an even greater degree without a debt ceiling deal. 

An old trading friend of mine used to laugh at my overwhelming interest in oil.

"Oil, gold, stocks, ha!" he would say, "All kid's stuff, everything is about bonds." 

He's right. You mess with bonds, you're playing with real dynamite. 

Let's hope we don't start seeing explosions come Thursday and I can go back to writing about oil stocks. 



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