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A ripple in a black pond

Whether you like it or not your life revolves around oil. Author Thom Hartmann refers to oil as “ancient sunlight” due to it being made from plants and animals compressed under our soil and oceans for millions of years. When you gas up your tank you’re literally burning dinosaur bones — thank you T-rex.

Oil is the most traded commodity in the world and if there is a disruption in the oil market you can be sure it will impact other markets. On Saturday an attack on Saudi Arabia’s oil infrastructure marked the single largest loss of supply on record. To put other historic moments in perspective take a look at the following infographic from Bloomberg:

Oil markets opened up Sunday evening nearly 20% above their Friday closing price. Any traders that were short going into Friday’s close got annihilated at the open as they scrambled to cover their positions.

Besides the obvious jump in crude oil prices, we saw a sell-off in global equities. This is not surprising as equity markets tend not to like international incidents that could lead to war. Many other asset classes moved as well. For example, Russia’s currency the ruble got a nice spike but other currencies associated with oil-exporting countries like the Colombian peso did not. This is despite the fact that Citi put out a piece yesterday suggesting that both RUB and COP would rise and rates in their countries would improve. We disagreed and we were right.

Examining Colombia’s market closer we note that it’s currency saw a drop, as did their equities and their bonds. In particular, their sovereign spreads, the premium at which investors demand to be compensated over equivalent duration U.S. treasuries, jumped. What does this tell us? It tells us that the global backdrop remains weak and that oil supply disruptions are more likely to hurt global consumers with energy price inflation rather than help oil-exporting nations finance their deficits.

In fact, our view is so different from Citi that we even see a currency trade between Russia’s ruble and Colombia’s peso. The ruble is much more prepared to benefit from oil spikes than Colombia. First of all Russian oil refining capacity is stronger and more efficient than Colombia. Second, the positive carry for the ruble is far greater than that of the peso. There’s an approximately 2.75% differential in favor of holding rubles and borrowing in pesos. A long RUBCOP position would have returned over 12% so far this year and that’s without adding the positive carry on top. That’s an attractive return and shows that not all emerging markets are the same.

Our current market view is that we are entering a period of stagflation. Core CPI is kicking up in the U.S., Canada, and elsewhere and we believe that inflationary trend is just the beginning. Oil shocks only serve to exacerbate that trend and we will see further dislocations in emerging markets as well as developed markets.

A pebble in a pond sends ripples. Toss in a bowling ball and everyone gets wet. Whoever is responsible for this weekend’s attacks just threw in the bowling ball.

Stay safe out there.