New Year, Same Story

Energy remains the crucial issue as traders await signals from the Fed.
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No one seems to have come back from the holiday weekend with as much enthusiasm as oil traders. After dominating headlines throughout most of 2005, energy again starts the new year at the top of the economic and political agenda, and the jitters are not leaving Wall Street indifferent.

Crude oil for January delivery was recently trading above $62 a barrel, after Russia -- the world's second largest oil producer behind Saudi Arabia -- flexed its muscles with the Ukraine.

Ukraine president Viktor Yushchenko refused to give in to Russian demands for a fourfold increase in the price of natural gas it supplies to its neighbor. Russian president Vladimir Putin and state-controlled

Gazprom

responded by cutting natural gas supplies to the Ukraine on Jan.1.

Russia provides roughly a quarter of Europe's natural gas supplies, and roughly 80% of it flows through pipelines in the Ukraine. Russia's decision was somewhat reversed Tuesday after protests from European customers whose gas delivery was affected by Ukraine sifting into the pipeline to make up for lost supply. Natural gas was recently trading down 31 cents at $10.91 per million British Thermal Units (BTUs).

But crude oil was recently trading at $62.45 on NYMEX, up $1.41.

The Russian/Ukrainian spat "is part of the story of the growing influence of suppliers in an environment of restrained capacity," says Jason Schenker, economist and energy analyst at Wachovia.

This story was indeed one of several recent ones reminding energy traders and Wall Street that energy will remain a dominant theme this year.

On Friday, Venezuela, the world's fifth-largest oil producer, took back control over 32 privately operated oil fields. And there's a lot of chatter among energy traders that the Organization of Petroleum Exporting Countries (OPEC) may to cut production when it next meets on Jan. 31 in Vienna, according to Dan Flynn, energy trader at Alaron Trading.

Furthermore, just before 2005 ended, Congress again rejected attempts to open the Arctic National Wildlife Refuge (ANWR) for oil exploration.

To top it all off, the weather in the northeast U.S. is currently returning to normal winter conditions after several weeks of warmer-than-normal temperatures.

"This is a nervous market," says Flynn. "I do believe that energy will stay in the headlines" at least through the early part of the year.

What does that mean for Wall Street?

Energy stocks were soaring along with crude, with the Amex oil index recently gaining 3.8%, led by big gains in the likes of

Occidental Petroleum

(OXY) - Get Report

,

Amerada Hess

(AHC) - Get Report

and

Marathon Oil

(MRO) - Get Report

.

But the broad market remained under pressure as rising energy prices combined with disappointing December sales from

Wal-Mart

(WMT) - Get Report

and weak economic data to spook traders. The Institute of Supply Management's (ISM) December manufacturing survey came in weaker than expected.

After spiking to as high as 10,678 shortly after the open, the

Dow Jones Industrial Average

tumbled to a post-ISM low of 10,684 and was recently up 3.76 points, or 0.04%, at 10,721.26.

Wal-Mart was weighing on the blue-chip average after its December same-store sales came in at the low of its previous guidance.

The

S&P 500

was up 2.93 points, or 0.23%, at 1251.22, and the

Nasdaq Composite

was up 1.17 points, or 0.05%, at 2206.49.

"We've got ostensibly higher oil prices, Wal-Mart and economic numbers on the weak side," says Joe Liro, equity strategist at Stone & McCarthy.

This, he says, is all playing into the scenario of slowing consumption in 2006, especially as home prices seem poised to continue cooling, capping home prices and the cash consumers have been extracting from them. "Consumers, particularly in the north, are going to take a hit when those heating bills come in," Liro says.

A slowing economy, however, should play favorably in the hands of bulls hoping that the

Federal Reserve

will soon stop its 18-month-long tightening campaign. The market is bracing itself for the 2 p.m. EST release of the minutes of the Fed's Dec. meeting, in which the Fed hinted that rates may be at "a neutral" level.

This had sparked hope that the Fed will indeed soon end its rate-hike campaign.

"But energy prices will remain a major determinant, especially if they keep on making new highs in the first quarter," Liro suspects.

Although there's been little evidence of soaring energy costs seeping into core inflation in 2005, it remains a distinct possibility in 2006, according to Wachovia's Schenker.

Although U.S. GDP growth should slow from its 2005 average pf 3.7%, it's still expected to grow at 3.3% in 2006, which is above trend. This, together with improving growth in Japan and Europe should continue to support strong demand for energy and boost energy prices, according to the economist.

"

Energy price pressures are trickling through via metals producers and will continue to create inflationary pressures," Schenker says.

His firm forecasts that the Fed will continue hike interest rates two more times -- lifting the fed funds rate to 4.75% by the end of March -- and will then pause to assess the economy. But Wachovia expects the Fed will then resume hiking rates to 5%, as these "inflationary pressures could get through to the core."

Whether or not these forecasts turn out to be correct, energy still seems poised to play a major role in the economy and market, at least in first part of 2006. As the French say, "the more things change, the more they stay the same."

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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