Oil: Supply and Demand? Hardly!

By Julian Murdoch

For most commodities, you can look at the underlying forces driving supply and demand and understand what will move the market. Except, it seems lately, for oil. Prices have risen so far, so fast from their mid-February lows that some investors have started to wonder: Is the price of crude decoupling from supply and demand?

Not quite. But right now, supply and demand only tells part of the story.

Oil Supply And Demand

Globally, we are awash in oil. As reported in the EIA's latest "This Week in Petroleum," crude oil inventories went up yet again this week, gaining 778,000 barrels. While this increase was less than half of the 1.91-million-barrel increase analysts had forecasted, crude oil inventory is still well above the five-year average for this time of year. (Oil still dropped a bit though, due to a huge increase in gasoline inventories when the market had expected a drawdown. See "This Week's Oil Guesses Off The Mark" for more on that story.)

OPEC has publicly stated that they believe inventories in developed OECD countries to be equal to roughly 61 days of demand—a number OPEC is none too happy about. They'd prefer the world to be constantly on the brink of running out (that is, 55 days or less). So with all of this supply, you'd expect to see OPEC talking production cuts—or at least a drop in the price of oil.

Instead, last week the group discussed the need to increase production, so as to keep oil under $80—it seems even OPEC thinks prices are still too high. As OPEC Secretary General Abdalla El-Badri told Bloomberg:

"Anything above $80 will really hamper economic growth. Watch the floating storage, if that is eliminated, and watch the stocks, if they are at 52, 54 days, then OPEC will take action."

Of course, if the floating stocks (that is, oil stored at sea) remain at current levels and inventories stay full, then apparently OPEC will just sit back and rake in the money.

It's The Dollar, Stupid

So if supply and demand isn't driving oil prices, what is?

It comes back to the strength—or lack thereof—of the U.S. dollar. As OPEC member Qatari Oil Minister Abdullah bin Hamad Al-Attiyah told Bloomberg:

"Sometimes the price of oil has no correlation to demand and supply. Now what we are seeing is that oil has a strong correlation with the dollar."

Of course, what he most likely meant to say is that right now, oil has a strong negative correlation with the dollar. Just look at the relationship between oil and the dollar since the beginning of 2007:

The top graph compares the movement of oil prices to movements in the U.S. Dollar Index, which measures the dollar against a basket of global currencies to show its relative strength (or weakness). Underneath, we've plotted the correlation between the dollar and oil over the same time period.

In periods of positive correlation (fairly rare for oil and the dollar), rising oil prices coincide with a strengthening dollar. But when the correlation is negative, increases in oil prices coincide with a weakening dollar—which is exactly what we're seeing right now. As the dollar moves down, oil moves up and vice versa.

Note that although the dollar doesn't swing very widely compared to the price of oil, the correlation between the two often does. In addition, it's rare that oil and the dollar move in lockstep—far more commonly, the two will move in opposition to one another.

There's an inherent logic to this: All else being equal, oil, being priced in dollars, should go up in price, simply because the dollar weakens on the world stage.

And as our friend from Qatar points out, we're at a cyclical nadir of correlation.

Where Does Oil Go Next?

With such ample supply and prices tied more to the dollar than demand, where does the oil market go from here?

Clues can be found higher up the supply chain, since oil, like all commodities, needs to be transported. Just as looking at the Baltic Dry Index reveals insight into the health of base metals and coal markets, we can look at the tanker industry to get a feel for where the oil market might be headed.

So far, all signs there have pointed to glut as well. There is ample supply of oil tankers in most areas of the world. In fact, rental rates on ships traveling from the Middle East dipped below running costs this year, because too many ships were available, allowing oil producers to have their pick of contracts.

That may be about to change, however, as rental rates are starting to rise on routes such as the one from Saudi Arabia to Japan, which had climbed 10 percent as of October 26. As the economy recovers and oil demand begins to rise, so too should rental rates for tankers.

Nor can we forget about China, whose demand for oil continues to grow; September imports were 15 percent higher than the previous year. China has also shown an interest in acquiring more oil resources, even though many of these deals have not gone through. Last week's "Weekly Tanker Opinion" by Poten & Partners, a global broker and commercial adviser for ocean transport, said the following:

"Though some future Chinese imports will be received through pipelines, tanker owners have reason to welcome China's recent energy investments as they will ultimately result in incremental increases in ton-mile demand. Chinese sponsored exports have already helped transform the West Africa to Far East voyage from a sleepy backhaul into a primary money-making voyage and Venezuela's increased exports to China have supported Caribbean to Far East rates."

The one fly in the ointment, however, is the 890 million barrels of capacity that should come online over the next few years in the form of new tankers. More ships will add noise to any effort to use tanker rates as an early-warning indicator of Chinese demand.

Does all this mean that supply and demand no longer matter? Of course not. But it does point to the momentary hypersensitivity of oil as a dollar play, not just an energy play. With the caveat that Chinese demand seems to be staying strong, there's little doubt the world is at least temporarily oversupplied—not at all-time highs, but replete with oil nonetheless.

Comments

[joes:]

If this is true "China is out there producing auto and diesel fuels from cola" then we should stop sending them coke:^)


On Oct 30 02:46 PM bindlepete wrote:

> Your really don't understand this market. There are not often single
> elements driving any decision out side of a coin toss and even these
> can be subject to influence.
>
> Most decision are multifactorial from access to transport, price,
> currency fluctuations ones own perceived needs and on ad infinitum.
>
>
> As to the supply side " peak oil' is a reality and inconvenient to
> acknowledge in our political system. China recognizes it clear and
> simple but then they have a different pattern of decision making.
> As to the many bbls you see coming on line it will be more than eaten
> up by declines in world production. Yes, even at $80 a bbl. with
> our dollar going down the porcelain pot hole.
>
> Hey, it is finite and difficult to find and produce. The US does
> not control the world oil market it is a world market and the big
> locals have little interest in low prices and certainly not cheap
> as dirt alternative liquid fuels.
>
> China is out there producing auto and diesel fuels from cola in the
> form of dimethyl ether and methanol. That is not permitted here as
> it would break the oil companies monopoly on feeding our liquid fuels
> addiction. Again China has a different decision making procedure.
>
>
> Oil priceas will continue to bounce about but with a clear upward
> long term trend. Bet on it. I have and am not ashamed of my comfortable
> success.
>
> I know you want a simple explanation but sorry all questions do not
> have human answers. Richard Belman taught me this back in 1970 over
> looking the Pacific.

Oct 31 11:06 AM

[a. palmer jr.:]

I've seen several people discussing term limits for Congress here and elsewhere...Actually each Senator and Representative already have term limits. It's the limit taxpayers are willing to put up with their Senator or Rep. If you're unhappy with him just vote him out! If you think he's been in too long, go to the ballot box and do something about it. I have been doing it for years now but I suspect others are merely talking and not voting. Maybe this time people will quit listening to what the politicians are promising to give us and remember that the politicians are mainly interested in what they can give themselves, not us and certainly not America.
I'll use one example: Illegal immigration. What person in their right mind, thinks that throwing the borders wide-open is in the best interests of America? Not that they're in their right mind, but almost all of the Senate thinks so. The Speaker of the House thinks so. Now, are they acting in our best interests or are they thinking of themselves and maybe some lobby money thrown in for good measure. Maybe they think it's ok to have people here that don't pay taxes because they don't pay their fair share either.

Oct 31 11:41 AM

[jdl51:]

If you limited trading oil contracts to people who actually have a connection to the product and get speculators out of the arena, the price would probably drop by half, regardless of what the dollar is doing. The oil market is a manipulated market and has been for a long time, whether you're talking about the producers or the futures market. The WTO should have come down on OPEC a long time ago, but are too afraid to do so. And why the U.S. doesn't have a comprehensive energy policy that takes advantage of our huge NG reserves, promotes alternative energy and lessens our dependence and monetary support of ME regimes that are the source of terrorism shows the power of the oil lobby in this country. It should be about what benefits everyone and not just a bunch of Texas oilmen.

Oct 31 12:20 PM

[Neal Barkett:]

I'm truley surpised that only TheGreates... brought up NATURAL GAS!!! We know have with the new deposit discoveries(an tech to extract) in our own United States, enough natural gas to run this country for at least 100 years. Our Politicians and we as citizens should be ashamed of ourselves. We spend billions fighting terroists that are bank rolled by us buying billions of dollars on foriegn oil. We deserve what we get because we don't either care about watching our elected officials or we are just too dumb as a nation we aer too busy watching American Idle, Entertainment Tonight, or Sports. While going on hearsay when it comes to important matter. We create this viscious cycle and are doomed to fail. Yes a weak dollar is one of the main reasons for the price of oil being so high in cost. But yet we don't realize that under our own feet is the answer "CNG COMPRESSED NATURAL GAS". If we want to invest in a real stimulus plan this is the natural resouce that will more than pay back the goverment stimulus as we move forward with installing the infrastructure to get it to where it's needed and retro fitting vehicles to run on the by far,CLEANEST OF ALL THE FOSSIL FUELS (it is even 20% lower in it's emmissions of CO2).
So why don't we tap into our own natural resource? Could it be the way Washington has been run for decades know, where the big special interest call the shots because they have the money to fund the campaigns so politicians can get re-elected? It's just like the hugh profits the Banks,Insurance companies & Big oil interests at the demise of our once strong nation. "We Sit Back & let it All Be", that's right we as a nation are so divisive we will fall pray to the media, both far left and far right. We are not a united people that can have our own opinions but in the time of true decision making we do what's right for the good of our nation. No, we follow the powers to be that have their own agenda that we think that has our best interests when really we are ponds in a nation on a chest board that is not only made overseas but heading to a point where people overseas will be deciding what is the next move on the board. We have to wake up. It is time to realize that we are still 10 to 20 years away from being weaned off foreign oil. If we invest in our own natural resources we create good paying jobs, help stop the flow of money to terroist organizations, strengthen our dollar and best of all lower energy costs for ourselves and cut the costs for businesses so they can do more business by being more competitive. People wake up and walk away from the heard before we reach the cliff.

Oct 31 12:27 PM

[MSimon:]

New methods of drilling will make it economical to recover oil from smaller pockets and drill deeper.

Right now drilling costs rise exponentially with the depth of the well. New methods promise linear costs vs depth.

Some links:

www.azom.com/news.asp?...

www.sciencedaily.com/r...

www.dallasnews.com/sha...

www.technovelgy.com/ct...

Oct 31 02:11 PM

[MSimon:]

"To say speculators are not driving it up is a joke. You only need to look at inventories to see that. But investors have proven they can't see such things."

Lots of people knew there was a housing bubble before the market broke. Lots of people knew there was a tulip bubble before the market broke.

BTW taxing energy is not the way to fix the oil/energy problem.

1. The government will just waste the money.
2. Raising the cost of everything is no way to induce a recovery.

Oct 31 02:17 PM

[MSimon:]

"Where will the world be when the oil industry has all the money? "

Where will the oil cos get customers if they have all the money?

Oct 31 02:21 PM

[Northstar10000:]

oil at sea is very carefully managed. they bring in what they want only. This is not random supply showing up at undetermined times.
oil will go below 60 than rise from there toward 100 by next june.

Oct 31 02:45 PM

[BRUCE E. W.:]

Flagrant Petroflation!

Oct 31 03:36 PM

[Old Trader:]

Northstar,

An excellent point, although I'm not convinced oil will go below $60/bbl. OPEC was unusually diligent in complying with quotas, when oil was at its lows, although compliance slipped as the price climbed. I'd suggest that if oil drops much below $70, you'll see compliance jump back up, adding support to the price.


On Oct 31 02:45 PM Northstar10000 wrote:

> oil at sea is very carefully managed. they bring in what they want
> only. This is not random supply showing up at undetermined times.
>
> oil will go below 60 than rise from there toward 100 by next june.

Oct 31 04:09 PM

[perceptions...:]

Mark,
"Supply and demand is ALWAYS the driving force behind the price movements.
ALWAYS. That's economic 101."

Whilst I understand where the comment comes from, it isn't ALWAYS so.

I would liken it to saying that "the market always gets it right". Perhaps, it eventually will, but it also invariably overshoots, both ways, there are some lengthy time lags and often there is vital information that is delayed, hidden or never presented.
That's economics reality!


On Oct 30 07:58 PM Mark Anthony wrote:

> Supply and demand is ALWAYS the driving force behind the price movements.
> ALWAYS. That's economic 101. If you apply supply and demand and could
> not draw the correct conclusion, that only means you missed something
> in your supply/demand equation.
>
> The one thing you miss in global oil supply and demand is the URGENT
> need for certain countries to increase their hoard of oil. Particularly,
> China URGENTLY needs to increase its strategic petroleum stockpile.
> The fact of the matter is China is hastenly building up infrastructure
> to be able to stockpile more oil and it could not build them fast
> enough, nor could it buy oil fast enough to fill up the new facilities.
>
>
> This is due to decades of neglect. For years China has been hoarding
> up a useless paper called US dollars, but neglect to hoard the more
> important stuff, petroleum, and critical industry metals.
>
> As it is now, China's petroleum stockpile is merely enough for 15
> days of supply. If China's oil importation is cut off, due to catastrophic
> events, within 15 to 30 days, China will be completely crippled.
>
>
> I don't think any Chinese leader can sleep well at night knowing
> that fact. I don't think China can buy enough oil fast enough to
> fill this void. This is one fundamental reason that oil price is
> driven up, regardless how you put the supply/demand numbers.
>
> seekingalpha.com/autho...

Oct 31 06:45 PM

[jerrydd:]

But taxing oil, coal will give us a tax cut, help getting off oil, cut imported oil costs, stop supporting Iran, Russia, oil dictators and since it will drop US consumption, it will drop the price of oil making Iran, Russia, oil dictators pay most of it.

By putting the cost in it makes a free market where all energy sources can compete on a level playing field. And with oil, coal going up with a bullet, RE which major costs are labor, equipment will make millions of new US jobs.

Or we can stay broke, at war and give all our money to our enemies, your choice. Basic econo 101.


On Oct 31 02:17 PM MSimon wrote:

> "To say speculators are not driving it up is a joke. You only need
> to look at inventories to see that. But investors have proven they
> can't see such things."
>
> Lots of people knew there was a housing bubble before the market
> broke. Lots of people knew there was a tulip bubble before the market
> broke.
>
> BTW taxing energy is not the way to fix the oil/energy problem.
>
>
> 1. The government will just waste the money.
> 2. Raising the cost of everything is no way to induce a recovery.

Oct 31 08:04 PM

[The Greates...:]

Crude inventories are rising, gas inventories are rising, so why does the price at the pump keep going up?
Every American need’s to call, write, fax and email their representative ASAP and ask these same questions! Where will the world be when the oil industry has all the money? The current world depression will not heal as long as fuel cost continues to escalate. The cost of fuel is the corner stone of any recovery because it affects every aspect of the world’s economy. It is so simple, just get off oil and start keeping our $25 Billion a month that we spend on foreign oil here at home to rebuild our economy. Our government has way too much oil money in it and Congress needs term limits. Where is the investigation into the oil and gas industry?

Nov 01 09:37 AM

[Floyd Brown:]

Oil prices are set on getting the most that can be gotten with out taking too much so that the public don't use less or push for other means of saving on oil.Put it this way: Those that deal in oil & gas want to get as much as they can from the system with out having changes to the system.Charge to much & there is increased demand for changes.If the pipe line flows smoothly all is fine. If oil supplies build up the cost of storing it is expensive. Those that would speculate on these times may or may not make any money. Don't look to that changing any time soon.At any time you may be rest assured that the main players: the oil & gas companies play the market to their advantage. Their cost stay the same but they price their product at the speculation prices. The major oil companies have long term contacts for their oil prices. If they get more for the end product they may see the the oil producers get more. The speculaters end up paying the oil producers higher prices for the oil. The only steady thing about this is that the gas using puplic pays for it all. Even if the public uses less, in the long run they will pay more. Even if we get other sources for energy the costs go up.

Nov 01 10:49 AM

[Tony Daltorio:]

You should try to get investment info somewhere besides CNBC or the WSJ. The Financial Times had an article a few weeks ago about how much of that floating inventory is gone and is still dropping as the large contango disappeared from the oil futures market. That oil has already been absorbed by the market.


On Oct 30 09:38 AM boby wrote:

> What do you think will happen when the market takes delivery of the
> 110m barrels floating?

Nov 01 11:26 AM

[WayneS:]

Gas stations have never made money selling gasoline. American refineries have lost money this quarter. We drivers waste 25-40% of the gasoline we buy. The price at the gas pump needs to go up so we can learn to use less gasoline and maybe help to stop our reliance on foreign oil.


On Nov 01 09:37 AM The Greatest Rip Off of our Time wrote:

> Crude inventories are rising, gas inventories are rising, so why
> does the price at the pump keep going up?
> Every American need’s to call, write, fax and email their representative
> ASAP and ask these same questions! Where will the world be when the
> oil industry has all the money? The current world depression will
> not heal as long as fuel cost continues to escalate. The cost of
> fuel is the corner stone of any recovery because it affects every
> aspect of the world’s economy. It is so simple, just get off oil
> and start keeping our $25 Billion a month that we spend on foreign
> oil here at home to rebuild our economy. Our government has way too
> much oil money in it and Congress needs term limits. Where is the
> investigation into the oil and gas industry?

Nov 01 12:11 PM

[Gadz:]

Never thought of that..good call.


On Oct 30 07:58 PM Mark Anthony wrote:

> Supply and demand is ALWAYS the driving force behind the price movements.
> ALWAYS. That's economic 101. If you apply supply and demand and could
> not draw the correct conclusion, that only means you missed something
> in your supply/demand equation.
>
> The one thing you miss in global oil supply and demand is the URGENT
> need for certain countries to increase their hoard of oil. Particularly,
> China URGENTLY needs to increase its strategic petroleum stockpile.
> The fact of the matter is China is hastenly building up infrastructure
> to be able to stockpile more oil and it could not build them fast
> enough, nor could it buy oil fast enough to fill up the new facilities.
>
>
> This is due to decades of neglect. For years China has been hoarding
> up a useless paper called US dollars, but neglect to hoard the more
> important stuff, petroleum, and critical industry metals.
>
> As it is now, China's petroleum stockpile is merely enough for 15
> days of supply. If China's oil importation is cut off, due to catastrophic
> events, within 15 to 30 days, China will be completely crippled.
>
>
> I don't think any Chinese leader can sleep well at night knowing
> that fact. I don't think China can buy enough oil fast enough to
> fill this void. This is one fundamental reason that oil price is
> driven up, regardless how you put the supply/demand numbers.
>
> seekingalpha.com/autho...

Nov 01 03:03 PM

[boby:]

@ Tony and ValueInvestor

I understand part of the priuce has been absorber. However I work in the oil trading/shipping industry and we are floating tons and tons of crude. So a delivery will have to take place at sompoint. Shipowners are still extending options due to the low spot market but as soon as it goes up traders will have to deliver the oil in NY and whever it has been sold. There are about 150m bbls being floated at the moment. The contango has closed for the crude but is still wide open for distillates and light ends. So i do think someone is going to have to take responsability, or in other words the oil spot will crash quite soon

Nov 02 09:12 AM

[StockMaster...:]

Good article. Oil is becoming a currency hedge that is here to stay. That is going to keep a premium above the fundamentals on the price.

Nov 03 12:19 AM

[rayrevol23:]

re. The Greates comments on Congress

30+ lobbyists per congressman and senator

Nov 03 08:48 AM