Petro-Countries Could Introduce a Major Shift in the Markets

As consumers gear up for Thanksgiving and then holiday shopping, they can add one more thing to their list of blessings – the falling price of gasoline.

Since most forms of shipping are propelled by oil, most everything we buy is affected by its changing price. With oil trading under $40, we’re getting a break that only a year ago seemed improbable to most.

And don’t expect prices to rebound anytime soon. The oil glut could be with us for years. OPEC members keep pumping out the stuff in an effort to drive shale producers in the U.S. out of business, and it looks like it’s working.

But that doesn’t mean the oil in the U.S. disappears. It will be there for when either prices go up or production costs drop. Because there is so much supply waiting at the edge of the market, it’s hard to see how prices could zoom higher without a major market disruption, such as a major war in the Middle East.

Continued low oil prices hurt the energy sector, no doubt. Cities in North Dakota, Louisiana, Oklahoma, and several other states that were beehives of activity just a year ago are now almost ghost towns.

But while these places are suffering economically, they don’t threaten the entire nation. The U.S. is fortunate to be the largest economy on the planet, with a wide diversity of industries.

Other countries aren’t so lucky. Their oil pain is going to be deep, and last for a long time.

When the U.S. was busy importing oil, running up its trade deficit, oil-rich countries were collecting dollars at a record pace.

Many of them took the opportunity to build their wealth instead of spending everything, pouring the dollars into sovereign wealth funds (SWFs).

Today, these funds are among the largest institutional investors in the world, with oil-based countries accounting for roughly $7.3 trillion dollars.

With oil trading at less than half of what it was in the summer of 2014, and petro-countries suffering with busted budgets, it’s likely these countries will have to sell some of these accumulated assets. They’re already expected to use all of their petroleum proceeds for social spending.

Norway is a posterchild for this situation. In the current budget cycle, the Northern European country expects to use all of its oil revenue for current spending needs, and to tap about 2.8% of its sovereign wealth fund.

The good news is, its sovereign wealth fund has amassed more than $800 billion over the past 19 years, and the fund is expected to grow by 4%. They can easily afford to liquidate 2.8%.

Saudi Arabia isn’t quite as fiscally sound.

The Kingdom’s reserve fund peaked around $737 billion in the summer of 2014. By August of this year, it was down to $654.5 billion. With no end to the oil glut in sight, the Saudis are looking for ways to trim their spending and have issued bonds for the first time in years.

Even blustery Putin isn’t immune to market forces. The Russian Reserve Fund, one of the country’s two oil funds, is worth around $140 billion. The country plans to spend almost half of this fund to address the current recession.

Other states, such as Qatar, the United Arab Emirates, Kuwait, and Abu Dhabi are all in the same boat.

Nothing good can happen when some of the biggest investors on the planet stop buying assets on the global market, and instead begin selling their holdings.

Large portions of these funds are invested in bonds around the world, while smaller allocations are in equities. As governments divert assets from investment to social spending, global markets will not only have fewer clients for existing inventory, but also potentially have to deal with more stocks and bonds up for sale.

The result, all else being equal, will be higher interest rates and lower stock prices – which is right in line with our forecast of where the markets were headed anyway. The added pressure from these sovereign wealth funds just adds more fuel to the fire.

There’s an opportunity here for investors.

We’ve long been calling for modestly higher interest rates and a selloff in the stock market, but things don’t stop there. We expect interest rates to climb a bit, then move lower as the economy cools off and investors leave the equity markets.

As Harry noted in Boom & Bust this month, now is shaping up to be a great time to buy bonds. Potential liquidations in sovereign wealth funds should make the opportunity even better.