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Oil Markets Fret Over ‘Fiscal Cliff’ Amid Leadership Change

Oil prices may gain this week after data from the world's two largest economies showed growth is stabilizing, but strategists warn leadership transitions in the U.S. and China will form the next set of challenges and could undermine any rally if policymakers don't deliver a clear roadmap on fiscal and economic reform.

Seth Joel | Photographer's Choice RF | Getty Images

Europe's debt woes will also continue to be on the radar with Greece's parliament set to vote on Wednesday on unpopular fiscal and structural reforms aimed at cutting government spending by 13.5 billion euros.

"Without a doubt the U.S. 'fiscal cliff' would need to be addressed as soon as possible," wrote George Boubouras, head of investment strategy & consulting at UBS in Sydney, warning there would be some fiscal drag in 2013. "Uncertainty is just not conducive for expanding earnings. The early signs of positive economic momentum, particularly last week's employment report and the recovery in U.S. housing, needs to continue and not be put at risk from policymakers."

Leading world economies pressed the United States on Sunday to act decisively to avert a rush of spending cuts and tax hikes, warning that the so-called "fiscal cliff" is the biggest short-term threat to global growth, according to a report from Reuters.

Unless a fractious Congress can move swiftly to reach a deal after the U.S. elections on Tuesday, about $600 billion in government spending cuts and higher taxes are set to kick in from January 1 and could push the U.S. economy back into recession.

"If the United States fails to resolve the 'fiscal cliff' it would hit the U.S. economy hard as well as the world and the Japanese economy, so each G20 country will urge the United States to firmly deal with it," Bank of Japan Governor Masaaki Shirakawa said before a meeting of Group of 20 finance ministers and central bankers.

U.S. crude futures hovered just under $85 a barrel in early Asian trading on Monday, as investors remained cautious ahead of the U.S. vote on Tuesday. Five out of eight of this week's CNBC survey respondents, or about 63 percent, expect oil prices to climb this week while three forecast a decline.

Justin Harper, market strategist at IG Markets, said of the firm's clients currently trading oil, 80 per cent hold long positions, "highlighting the bullish sentiment and a feeling that energy markets have softened too much."

Polls show President Barack Obama and Republican challenger Mitt Romney are deadlocked nationally, although the president appeared to have a slight edge in the swing states that will decide who captures the 270 electoral votes needed to win on Tuesday, Reuters reported.

Such a close race, compounded by ballot counting problems, may result in failure to reach a decisive outcome, according to some market watchers. That uncertainty could pressure oil markets, creating some volatility in the short term, said Mark Waggoner, president at Excel Futures, who has a 'bearish' recommendation and is looking to re-enter and add long positions, or bets that prices will rise, at $79.60 a barrel.

One of the few bullish respondents to the survey Sean Hyman, Editor of The Ultimate Wealth Report, said he'd buy at the current levels, buy more on any weakness below $80, "then hold what I had until we hit the triple digits again."

Weighing on Fundamentals

Outside the leadership changes this week, oil markets are weighing up supply and demand balances in the U.S. after Hurricane Sandy ripped through the East Coast last week causing damages estimated close to $50 billion.

Typically, the storm season has impacted production in the U.S. oil patch in the Gulf of Mexico, creating supply shortages as oil rigs are shut down or damaged by the severe weather. Sandy, however, is being seen as a demand-destruction event for oil markets after it brought economic activity to a standstill in major cities along the eastern seaboard.

(Read More: There's No Gasoline Shortage: Pickens)

Mark Zandi, chief economist at Moody's Analytics, pointed out that economic activity in the region spanning between Washington D.C. and New York City amounts to about $2.5 trillion per year. That means that when the area hunkered down for two days to wait out the storm, the economy likely lost $20 billion in activity.

"Fundamentals continue to point to lower prices," wrote Andrew Su, CEO of Compass Global Markets, who has a 'bearish' recommendation for oil in the medium term and 'neutral' in the short term. "Production of crude in the U.S. has surged almost 40% since the beginning of 2009 even as demand for product such as gasoline falls. Crude output is at the highest levels since 1995 while inventories remain high."

He added: "In the context of a Europe still on the brink and uncertainty in both the two largest economies in the world, we have no hesitation in re-affirming our bearish outlook for crude and our end of year $80.00 target.

Europe Still Matters

Though the markets will be transfixed by the leadership changes in the world's two most powerful economies, Europe could be the outlier for markets in the short-term.

Greece's government will present a new austerity package to parliament on Monday, facing a week of strikes and protests over proposals, which must win deputies' approval if the country is to secure more aid and stave off bankruptcy, Reuters reported.

(Read More: Greece Makes Austerity Push, Workers Gear for Strike)

Parliament is expected to vote on Prime Minister Antonis Samaras' package of 13.5 billion euros ($17 billion) in cost cuts and tax hikes on Wednesday along with measures making it easier for firms to hire and fire workers.

"We're bearish over the near-term and anticipate concerns about Europe continuing to resurface after the distraction of the U.S. election is over," Kirk Howell, partner at Spy Ridge Capital, who has a 'bearish' recommendation over the short-term. "The headline NFPs (Non-Farm Payrolls) were better than expected, but risk assets still sold off and we believe will test lower levels over the next few weeks."

The aftermath of Hurricane Sandy will make data, including the Department of Energy's weekly supply report, "over the next few weeks tough to read and we'll be careful not to overreact," Howell said. "Similarly, we'll be interested to watch the leadership transition in China which we believe is a bigger market event than the U.S. election this week."

China's eighteenth Communist Party Congress, which begins in Beijing this Thursday, will appoint the new leaders for the world's second-largest economy for the next decade. Vice-President Xi Jinping is widely expected to succeed Hu Jintao. Some press reports suggest the influential Politburo Standing Committee will be populated by 'old-guard' conservatives who may jeopardize the reform program.

This suggests "that the hardliners have dominated the internal debate ahead of the 18th congress," said independent strategist Patrick Perret-Green. "This is unlikely to be good news for the reform process or for domestic confidence. Indeed, if you think that capital flight is going to ease, think again."

—By CNBC's Sri Jegarajah

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