A lot of money can be made by timing our investments correctly. One of the most liquid and interesting asset is crude oil, which we expect to ocillate with changing market expectations and global economic drivers. We had a decent forecasting crude oil price record in 2011, and would like to share with the readers some of the indicators we look at. However, the beta of crude oil price to different drivers is changing, and care should be taken in taking a long position in crude oil futures, options, or physical markets.
US Economic Indicators
US economic indicators are a story of rising expectation through H1 2011, which became too high to be fulfilled by the end of Q3 2011, which was the point at which a dip in crude oil price happened. After the disappointments in August and September, economic expectation dipped lower, and the market was surprised positively in October by initial jobless claims, unemployment, manufacturing and non-manufacturing PMI/ISM, inventories (finished and raw), order backlog, delivery delays, new orders, nonfarm payroll numbers, retail sales, consumer confidence and revisions and numbers on GDP growth rate.
The picture that appears from the economic indicators is that US trade, manufacturing as well as non- manufacturing inventories are at average levels as US vendors were selling from inventories in Q2 and Q3 2011. An increase in new orders will replenish the orders backlog in Q4 2011 - Q1 2012. ISM employment in the service sector is expected to remain relatively weak in coming six months, but there will be a pickup in manufacturing side.
Consumer confidence has stayed better, and has generally resulted in a better than expected sales number for the last three months. On that note, RTCL, a ratio of coincident to lagging indicators, which leads the index of leading economic indicators, has been slowly turning positive. Some of the other indicators, like motor vehicles sales and number vehicles miles driven, are also painting a better than expected picture of gasoline consumption in the US. Further, dips in refining margins have been followed in dips in crude oil price, as commercial users of crude oil cut back on utilization runs, which increase the crude oil inventories and decrease the imports and bears negatively on crude oil price. The current refining margin of around $7-$7.50 per barrel is low, and it is expected to reverse to US $11 per barrel, which is 36% higher compared to the current level. A reversal in margins may be followed by uptick in crude oil price by YE 2011.
In recently released Fed Beige Book, the Fed remained cautious on economic outlook. The major takeaway was that The U.S. economy continues to expand at a modest pace, but with weaker or less certain outlook. According to the report, consumer spending was up slightly since the last report, with auto sales and tourism leading the way in several of them. Business spending increased somewhat, but there was restraint in hiring and capital spending plans.
U.S. residential and commercial real estate remained weak. The Fed also noted that labor market conditions were little changed, on balance, in September. The U.S. economy only grew 0.9 percent in the first half year. It is expected to grow faster in the second half of 2011, but may not surpass 2.5 percent. We expect most of these indicators to remain mired in a cycle of build up and draw down, which will act as the market driver in H1 2012.
The key issue in the US will be improvement in business confidence, which has stayed low for one reason or another. Fiscal tightening is a risk, but Congress is expected to reach agreement on $1.5 trillion in government spending cuts by a November 23 deadline. If a deal is reached before then, the United States could avoid triggering an automatic $1.2 trillion in cuts evenly distributed between military and non-military spending, which Pentagon officials warn would damage US interests. The discussions had taken place under the shadow of a repeat of political stonewalling by the Republicans, who earlier in the year withdrew from talks with Democrats on lifting the US debt ceiling. We expect an oscillating flat equity markets – WTI will trade in a range, averaging US $86 per barrel for 2012.
Chinese Economic Indicators
China is responsible for around 60% of total world crude oil demand growth, both in 2010 and 2011). The crude oil market is worried about sustainability of China's economic growth because of an anticipated drop in exports and concerns over the financial health of some of the banks and cooling property markets.
We believe the overall picture of China’s economy will remain stable, despite some headwinds relating to inventory cycle and the effects of monetary tightening. We see China’s export orders, new orders, backlog, PMI, input purchases, industrial production staying stable to positive.
China is an export-driven economy, and its order backlog is key for future industrial activity. Order backlogs started contracting from June 2011, but since July at a declining rate, being last reported at 49.5 in September 2011. Suppliers' delivery times also declined in Q3 2011, but at slowing rate, last reported at 49.5 in September 2011. However, new orders are still expanding at an accelerating rate, as PMI new orders were reported at 51.3 in September 201. We expect this to result in an improvement in the orders backlog, as well as suppliers' delivery times, by year-end 2011.
Further, stocks of finished goods were declining, as China Inc was selling out of inventories in Q3 2011 (49.5 in September 2011 from 49.9 in August 2011). Raw material inventories declined even faster, as PMI reported 48.8 in August 2011 and 49 in September 2011. This shows that manufacturers were cutting back on purchases and selling from inventories as they saw some weakness in orders in June 2011. However, inventory cycle (contracted) does not last more than six months, and purchases are expected to pick up, which should be positive for commodities in general and crude oil in particular. Crude oil market may face gyrations on inventory ebb and flow and negatives related to the property cycle.
European Economic Indicators and News Flow
Expansion of the ECB balance sheet to monetize its way out of trouble will definitely be positive for riskier assets and crude oil prices (as against negative correlation of the previous year). The key issue in the case of the euro is that traditional model of insolvency and currency devaluation monetizes the domestic debt, creates monetary austerity (by making imports expensive) and makes the economies more competitive.
The EU may keep facing the problem of flexibility of monetary policy and political divisions. According to a semiannual report from Germany's leading economic think tanks, released on October 12, following rapid growth at the beginning of the year, the German economy has all but stagnated. However, the latest indicators, like I/B/E/S survey and ZEWS, show that Germany had a pickup on new orders in September 2011.
However, overall EU industrial production will remain in a stagnant to falling zone in 2012. Notwithstanding a negative economic outlook for EU region, even if European banks do run into trouble as a result of a possible Greek insolvency, "contagion of the same extent as after the Lehman Brothers bankruptcy [is] very unlikely." In terms of solace, though, that's about all there is.
According to above-mentioned report, German economic growth forecast for 2012 has been slashed from 2.0 percent to a mere 0.8 percent. And it's not just Germany. The report forecasts that production in the eurozone as a whole could actually contract slightly this winter as global demand dries up. A recent report on eurozone economic activity issued by global consulting firm Ernst & Young lowered its 2011 growth forecast for the common currency area from 2 percent to just 1.6 percent. For 2012, the consulting firm expects a growth rate of 1.1 percent, down from an original forecast of 1.6 percent.
Although the economists did not identify an immediate threat of recession, they are pointing to a more challenging economic situation. European economic situation affect Brent more than they do to WTI. Still, Brent traded at a premium to WTI because of supply constraints emerging from Arab spring. Prices are still being driven mainly by optimism that a comprehensive solution to the eurozone debt crisis will be found in the near term. The key which can affect Brent price in 2012 is progress on expanding the EU bailout fund and recapitalizing banks.
Money Supply in China, the EU, US and Emerging Asia
China’s M2 started increasing again in Q3 2011 after some deceleration in middle of 2011. In a regime of no further tightening, the money supply growth may be touching 22% by Q1 2012. China money supply growth has historically been positive for crude oil price. With no tightening in sight, US money supply is expected to remain high and China money supply will be higher in Q4 2011 and Q1 2012. The weakest link is the EU, which as shown money outflow. It is expected that money supply will increase with the expansion of the ECB balance sheet after some progress to support the debt.
US Inventories of Crude Oil and Products
US crude oil inventories, last reported at 339 million barrels, have declined below their 5-year average (327 million barrels) because of some draw-down and release of 60 million barrels into the market by US government. The gasoline inventories were last reported at 211 million barrels, almost at the 5-year average of 209 million barrels. Crude oil inventories will stay loose in H1 2012, but start tightening in H2 2012, as affected by a rise in US gasoline demand supported by an increase in vehicles sold, an increase in number of vehicle miles driven and a general improvement in industrial activity.
Crude Oil Market Fear
CDS spreads on some of oil majors and, to a lesser degree, option-implied volatility will serve as a fear gauge for short-term crude oil price inflections. Option-implied volatility has come down from the high of 51% to the current of 48% against the long-term average of 41%. But there is a potential for this gear index to decline 10-15% further, as it tends to do drop to 30% level and cause crude oil price increase in the process. We expect gyrations to happen in 2012, which may give us windows of opportunity to invest in equity markets and oil-related stocks.
Spare Production Capacity
We expect spare production capacity of OPEC to be higher than average at 4.3 million barrels per day, up from 2.7 million barrels per day in Q2 2011, and slightly tightening in 2013. The normalized level of spare production capacity to keep crude oil price stable is around 3.5 million barrels per day.
Social Unrest and the Pace of Libya Supply Increase
It may be too speculative to call a resurgence of social unrest in Saudi Arabia (despite some report of Shiites protests in Khatif), Oman and Bahrain, but if happens, crude oil price may spike. WTI premium to Brent crude oil price shifted to a discount because of uncertainty about Libyan oil supplies (1.7 million barrels per day, 2% of global oil output). Libya is not expected to produce at prewar levels at until least well into 2013. However, the output may cross 1 million barrels per day in H1 2012. Unless the OPEC quota compliance ratio does not rise to 80% from current estimated at 60%, we may expect an oversupplied market, which may bear down on crude oil price in 2012.
Trade-Weighted US Dollar: We expect US trade-weighted dollar to keep reverting to the near-term mean reverting level of 73, with a standard deviation of 10% and a probabilistic reversion to mean. The correlation between dollar price crude oil may stay stronger than 0.5, and a fundamental as well as technical outlook on direction of US dollar may be good short term indicator of crude oil price movement.