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Wednesday Look Ahead: Oil Pressure Rises on Financial Markets

Markets are grappling with new concerns that rising oil prices could stifle the economic recovery and steal away stock market gains.

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AP

The escalating situation in Libya, where Muammar Gaddafi vowed to crush the revolution, drove April crude more than 8.5 percent higher Tuesday to $93.57 per barrel. Stocks tumbledon the second heaviest volume day of the year. The Dow fell 178 points, or 1.4 percent to 12,212, and the S&P 500sank 27 points, or 2 percent to 1315, the edge of a key technical zone. The Nasdaq was severely battered, falling 2.7 percent to 2756.

Investors ran to the safety of Treasurys, driving yields lower. The 10-year was yielding 3.465 percent, its lowest level in three weeks. The dollar gained 0.2 percent against the euro, but lost 0.4 percent against the yen, which benefited from a flight-to-safety trade of its own. The VIX, the stock market's fear gauge, also jumped sharply, rising more than 26 percent to 20.80.

"One day does not make a trend. We saw that two weeks ago. We have to see how it plays out," said Dan Deming, who trades the VIX, with Stutland Volatility Group. Deming said the VIX also soared when the market sold off on unrest in Egypt last month, but it reversed course as the market steadied. The situation this time is much more uncertain, as Libya, an oil producer, is in chaos with about 30 percent of the country controlled by rebels and the rest in the hands of Gaddafi.

Libya declared a force majeure on oil production Tuesday, according to Reuters. Senior U.S. officials later told NBC News that there is no evidence of damage or a change in control at Libya oil facilities.

Traders were also watching as two Iranian war ships passed from the Suez Canal into the Mediterranean Sea in the first such crossing in 30 years. Some Israel officials called the act a provocation. Israeli Prime Minister Benjamin Netanyahu Tuesday accused Iran of trying to exploit the uprisings in the region and to use its influence to thwart democratic reform.

What to Watch

Besides Middle East developments and the price of oil, Wednesday's markets will also be watching for January existing home sales data at 10 a.m., and the Treasury's auction of $35 billion in 5-year notes. Philadelphia Fed President Charles Plosser speaks at 1:30 p.m. on the economic outlook, and Kansas City Fed President Thomas Hoenig speaks at 12:30 p.m. at an event on housing and finance.

Hewlett-Packard will also be a factor Wednesday, and it could have a big impact on the Dow. Hewlett stock tumbled more than 11 percent late Wednesday after the company reported disappointing revenues and cut guidance for the year.

Oil Drill

The rise in oil prices comes as the market in increasingly focused on inflation pressures. One of the biggest debates now is how high oil and gasoline prices might go on the situation in Libya and other parts of the Middle East. Libya produces about 1.6 million barrels of oil a day, or about 2 percent of global production, but it is a very high quality crude. Traders speculated Tuesday that as oil moves higher, gasoline prices could shoot up to a national average of $4 per gallon or even higher, in the not too distant future.

"I think things are going to calm down in terms of the oil market response," said Thomas Kloza, chief analyst at OPIS. "...We're looking at something that's probably going to take us to $3.50 to $3.75 (a gallon average for gasoline), which is a point that results in a lot of weeping, wailing and gnashing of teeth but probably doesn't have a big impact on demand."

"I'm much more temperate than most people on the story of gasoline, and where prices are going. Everything I tell you has one caveat. If we wake up one morning and have violence in Riyadh or Jeddah in Saudi Arabia, then all bets are off," he said. Saudi Arabia's deputy oil minister Tuesday told CNBC that Saudi would make sure there are no supply disruptions as Libya struggles.

Economists have differing views on where they think oil prices become a problem for the economy. Deutsche Bank's Joseph LaVorgna said he sees trouble for the economy if oil hits $125 per barrel.

Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi, however, said even $100 a barrel could be a problem. "It starts to get to the danger zone. I think the problem there is it's not just crude oil. It's the impact on the consumer and the impact on the consumer comes primarily through gasoline prices and gasoline prices have moved up about $0.40 since late last year to $3.20, even before the weekend's events," he said.

Rupkey said he's already concerned about the consumer's reaction to the higher gasoline prices. "I'm a little worried about gas going to $3.30 a gallon or so. That would start to rob the consumer and take away discretionary income. They don't tend to cut back on their driving as much as you'd think. They do tend to cut back on goods and services. We've seen this happen," he said.

Consumers ultimately adjust to higher gasoline prices, but it takes awhile. "The lesson in history is consumers can get used to higher oil prices, but not initially and not before we rally Treasurys and stocks come off 5 to 7 percent," he said.

James Paulsen, chief investment strategist at Wells Capital, said he thinks the higher oil prices would become a problem for stocks and the economy if gasoline were to hit $4 and the 10-year yield was also simultaneously rising, to the 4 percent level or above. "This combo or some combination thereof would certainly likely dent momentum in the recovery," he wrote in a quick email.

"However, we are a long ways from these levels today........oil prices have leaped by $5+ but are not even back to where they were a couple weeks ago........gas futures prices have risen to new cycle highs and they are more important than oil prices but they are also currently "ahead" of where they should be trading relative to oil prices. Most importantly however is even though gasoline prices are rising, the 10-year treasury yield has declined back toward 3.5 percent. Gas up a little, yields down a little.........in my view, not yet much "bite" on this economic recovery," he wrote.

Rates Falling?

Uncertainty in the Middle East drove buyers intobonds, but CRT Capital chief Treasury strategist David Ader said there was more to the move Tuesday. "We've had an important technical move that can't be understated," he said.

The market was oversold, and as investors jumped in, they drove the yield on the 10-year sharply lower. It crossed the important 3.56 percent level, which was the peak in the yield around mid-December. Ader said it then broke through the 3.50 level. "With the technical activity here, which to me suggests that we could entirely retrace that lost range. 3.25 percent 10-year notes is not outside the realm of possibilities," he said.

Ader said he is watching the 3.375 level to see if the market finds support there.

"As you think about this market, one of the things that challenges me a bit is we had the curve flatten today quite a bit. If this is a flight to quality because of true concerns about the Middle East, for example, you'd think the curve would steepen not flatten. The fact we didn't steepen really underscores the technical nature of the move. This reeks more of an unwind," he said.

Ader said month end is also probably coming into play. He said he expects Wednesday's 5-year auction to go well and that the yield should move lower, to potentially as low as 2 or even 1.90 percent. It was yielding 2.151 percent late Tuesday.

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