Black gold over the top?

Problems on the American subprime markets have caused many problems to financial institutions. Not only hedge funds, but also 'normal' banks like the German IKB Bank and Sachsen have lost billions of dollars. Subprime is the riskiest part of the US mortgage market. Customers with a very poor credit rating have been 'served' on this market and, of course, they had to pay a risk premium.

An explosive cocktail

As long as house prices went up and interest rates stayed low, there was no problem. However, house prices went down and, even worse, interest rates went up. A cocktail of explosive ingredients was the result. Debts could not be paid back by borrowers, leading to provisions and even worse, credit defaults.

Financial institutions subsequently became cautious about lending to other banks, thus creating a severe credit crunch, which is ongoing. The central banks pumped billions of dollars and euros into the banking system. Meanwhile, the US Fed even lowered the discount rate by 50 basis points. The market is waiting until the Fed lowers the federal funds rate. This is expected to occur during a meeting today, September 18.

But what has this got to do with oil? Well, since July stock markets have crashed. After hitting a bottom in August, markets then rallied. Remarkably, oil prices have followed the stock markets. Oil also fell from the top in July towards a level of $70 at the end of August. But since then hurricane season has arrived in the Gulf of Mexico and oil output has been cut back by the occasional closing of drilling platforms in that region.

Dollar boosts oil price

But hurricanes are not the only factor which has driven oil prices to a new all time high of $81. The weakening dollar, which has hit an all-time low versus the euro, has contributed to the rally. The question is whether the sky is the limit or if oil prices will stabilise or even drop from their current level.

Don't forget that, at the top of the mountain, the view is always best. But it is very easy to fall headlong into the valley. The fact is that, at the current level, oil will be vulnerable to events like the recent production increase by Opec or diminishing hurricane threads.

It might be wise to lock in some of your profit. Last year, oil prices dropped approximately 35 per cent to around $50. Of course this could happen again. Moreover, if the global economy slows down, this will lead to a diminishing demand for oil.