A confluence of recent events will likely weigh on the price of oil and other commodities into the end of this year. Manufacturing weakness in China suggests that general demand for oil and building materials (such as copper and other metals) will remain soft in the coming months. Moreover, the latest congressional testimony from Fed Chairman Ben Bernanke indicated an increased likelihood that policy makers will elect to slow the rate of its stimulus program, currently equal to $85 billion in mortgage-backed securities purchases each month.
The combined effect of these developments suggests that investors should consider taking long positions in the U.S. dollar, and short positions in oil and oil-producing companies. This can be done using instruments like the PowerShares DB U.S. Dollar Index Bullish (NYSEARCA:UUP), which ties its value to the U.S. dollar. Conversely, the bearish scenario creates an opportunity to sell the iPath S&P GSCI Crude Oil Total Return (NYSEARCA:OIL) and Exxon Mobil (NYSE: XOM).
Slowing Manufacturing, Weaker Oil Demand
China's HSBC Purchasing Managers' Index for the month of May came in at 49.6, which is the survey's lowest level in seven months. For these reports, numbers below 50 indicate contraction and this follows the modestly stronger 50.4 result that was seen in April.
China is the world's second largest consumer of oil, and continued declines in manufacturing activity limits demand in one of the biggest markets for the commodity. Trends like these will continue to sap demand prospects for oil and instruments like the iPath S&P GSCI Crude Oil Total Return Fund, which track the price of the commodity. In addition to this, manufacturing rates in the U.S. (the world's largest oil consumer) are also showing weakness, albeit at expanding levels. In all, this is bearish with significant exposure to the commodity scenario for oil (and its associated funds) and creates an argument to begin selling funds and companies with significant exposure to the commodity.
Another factor to consider is this month's congressional testimony from Fed Chairman Bernanke. A more upbeat view on the labor market and broader economy has led to suggestions that quantitative easing stimulus can start to be phased out. This is bearish for oil prices in a number of different ways. First, the end of quantitative easing is a negative for stock markets but a positive for the U.S. dollar. Commodities like oil are priced in dollars, to what is positive for one is negative for the other.
Furthermore, tighter monetary policy means slowdowns in economic activity. Reductions in manufacturing and productivity means less demand for energy. On balance, a change in policy stance from the Federal Reserve is bullish for the currency (and for long positions in PowerShares DB U.S. Dollar Index Bullish), and negative for oil shares and commodities.
Outlook for Oil Remains Negative
Oil prices are trading within striking distance of their yearly highs. But given this elevated valuation (relative to short-term averages), there is much more risk to the downside than there is potential for the topside. Looking at specific stocks, this creates selling opportunities in Exxon Mobil, which has already started to see declines in production and refining, and has posted flat-lining profits for the first quarter. The figures were somewhat misleadingly encouraging, however, as a stronger performance in the company's chemical business partially offset the weakness in other areas.
So, the reality is that the framework is in place for Exxon Mobil to start giving back the nearly 8% rally the stock has seen so far this year. Exxon Mobil is the world's largest publicly traded oil company, and has continued to show disappointments in terms of production trends and this concern will likely be compounded by the larger market outlook. Production levels decreased by 3.5% for the first quarter of 2013 (on a yearly basis). Positives can be found in the company's AAA credit rating and relatively stable balance sheet. But Exxon Mobil will need to find ways of adapting if upside earnings surprises can be expected next quarter.
Macro trends and changes in government policy will start to weigh on productivity, diminish demand and strengthen the U.S. dollar. There are few positives in this scenario for oil and for stocks like Exxon Mobil. Until we start to see changes in manufacturing activity or sufficient healthy demand for energy products, these bearish trends are set to take hold and continue into the second half of the year.