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Oil Prices May Rally on a U.S. Default

NEW YORK ( TheStreet) -- If the U.S. does indeed default on its debt or suffer a credit rating downgrade, oil prices could rally on ensuing Federal Reserve and investment diversification actions, analysts agree.

In either of those cases, "you're going to see the Fed react to that very swiftly and aggressively," says PFGBest senior energy analyst Phil Flynn. "Initially everyone will freak out and say 'oh my gosh ... demand destruction' " in the world's No. 1 oil-consuming nation, but then reverse their views upon another round of government stimulus or quantitative easing III, which would bring an influx of hot, speculative money into the commodity markets, Flynn explains.

Summit Energy analyst Matt Smith agrees with Flynn to a lesser degree, saying that another round of quantitative easing would cause investors to immediately consider commodities as an inflation hedge, given that it would support dollar weakness and heighten inflation expectations. But "I think the view is tempered by the negative realities of quantitative easing."

To Smith, quantitative easing is a "necessary evil" -- a bandage -- rather than a long-term solution to the health of the general U.S. economy, which, of course, is required for strong oil demand.

Most analysts whom TheStreet spoke with agree that a U.S. credit downgrade is more likely to happen than an actual default because, as Mirus Futures chief market analyst Kurt Kinker explains, bringing down the overall level of U.S. debt would "would require big cuts in spending. I don't think that's likely to happen ... it would be difficult for politicians to make the cuts."

A default on the other hand would likely be prevented; most analysts believe that Democrat and Republican lawmakers will eventually reach a deal to raise the country's $14.3 trillion borrowing limit, even if it's past the Aug. 2 deadline.

Flynn of PFGBest believes that a downgrade would also be bullish for oil, encouraging an inflow of money away from U.S. debt and into higher-yielding emerging markets debt; then they would invest the proceeds from their emerging markets investments in oil. Flynn said a good example of this is China's recent diversification away from U.S. debt and into European debt and commodities.

Smith agrees that a U.S. credit downgrade could spur diversification into oil, but points out the longer-term ramifications of such a downgrade: a lack of confidence and therefore investment in the world's largest oil-consuming nation, which could have a detrimental effect on the U.S. economy -- hence, oil demand.
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