Crude Oil Price Reversal Only a Matter of Time

by: Irfan Chaudhry

Crude futures fell sharply on Monday, (-4%) as S&P’s downgrade of the U.S. credit rating strengthened worries about the economic recovery and demand for oil. This is really a continuation of last week‘s decline. The fundamentals for oil markets have been weakening in most of Q2 2011 with demand softening as result of higher gasoline prices despite supplies being tight on lack of exports from Libya. Front month crude (NMN - CL1U) dropped $3.31, (-3.8%), at $83.57 a barrel on the NYME. The contract earlier hit an intraday low of $82.52 a barrel. Oil lost 9.2% last week — including a pullback of nearly 6% on Thursday that sent prices to their lowest since mid-February. Other energy products tracked oil lower, with heating oil leading the way. Front contract (NMN - HO1U) lost 7 cents, or 2.4%, to stand at $2.86 a gallon. September gasoline (NMN - RB1U) declined 5 cents, or 1.8%, at $2.75 a gallon.

This raises some key questions about the current deflationary spiral. Despite heightened uncertainty around the outlook for commodities, we are still keeping a constructive view for the sector’s prospects. Factors include still-higher than expected world GDP growth/EM world, sufficient to tighten key commodity markets and commodity-supply tightness that have substantially offset if not dominated demand disappointments in key markets. For oil, it’s only a matter of time before inventories and OPEC's spare capacity will become effectively exhausted, requiring higher oil prices to restrain demand. The recent decline in the price of commodities and equities decrease the valuations with a very little effect on forward earnings/demand estimates (which have remained subdued). The spat of negative economic news will set the stage for economic data surprising to the upside. Market participants (especially managed money) will treat it as positive news for crude oil demand and crude oil price. The main factors for this view are:

  • Weakness in US$ should be supportive of crude oil price as against 2008 deflation when US$ gained strength because of safe heaven demand.
  • The effect of the downgrade on asset prices will wear off as it is not expected to result in a credit freeze of post-Lehman type.
  • The European Central Bank signals it would buy up Spanish and Italian bonds on a large scale. Here’s what the move would mean for financial markets and the future of the eurozone: China’s near term tightening cycle may take a breather and eurozone debt problems would have been digested by the market.
  • If negative economic news persists, that may increase the probability of another go at an asset repurchasing program – with the FED pumping additional liquidity in the system. This will be supportive of the crude oil price by increasing the asset prices (equity market and crude oil correlation may stay strong) and decrease in US$, which would be positive for dollar priced crude oil. In either of these binary scenarios the crude oil supplies still remain tenuous as we expect some resurgence of political problems are likely to resurface in the Middle East.
  • Gasoline and product prices decline will have a positive effect on OECD crude oil consumption.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.