A Significant Correction In Crude Is On The Way

Includes: ERO, FXE
by: Disruptive Investor

In general, crude oil and the dollar share a high negative correlation. Apart from fundamental factors, a weak dollar has always been one of the major reasons for upside in crude oil prices.

However, if one observes the trend in the recent past, the dollar has been strengthening along with upside in crude oil prices. As I mention this, I do have in mind other factors, which can lead to upside in crude prices even when the Dollar is strong.

Having said this, I expect crude prices to correct meaningfully in the near-term due to several fundamental factors. Discussed below are some of the major reasons, which might trigger downside in crude.

The eurozone crisis is expected to be relatively prolonged. A weakness in the euro would mean relative strength for the dollar. Further, if the crisis worsens, global liquidity tightening can lead to major correction across all asset classes. Therefore, there is a high likelihood that crude prices would correct in the near-term owing to a stronger greenback.

The sovereign debt crisis in the eurozone is already showing its impact on economic growth. As growth flattens out with even a recession being a high probability, the demand for crude might decline leading to correction in prices.

China, once touted as the driver of global growth, might surprise significantly on the downside in the foreseeable future. The business cycle signal index for China has declined from 113 in June 2011 to 105 in September 2011. Clearly, there are signs of cooling down for the economy, which has been a major driver for commodity prices. Any further bad news from China (highly expected), will lead to a meaningful correction in crude prices.

India, another economy, which has been doing relatively well in the midst of the crisis is also showing signs of weariness. The index of industrial production for September slumped to 1.9%, indicating a meaningful slowdown across the industrial sector. India is not one of the major consumers of crude. However, it does contribute to an overall sluggish global growth leading to negative sentiments for the commodity.

I did not mention the U.S. economy, as it has been holding up pretty well. Further, the festive season should give consumption some boost to keep the relatively positive sentiment going in the near-term. The real test for the U.S. economy might come in the first quarter of 2012. Given the way things are shaping up globally, I don’t see the positive surprises to continue into 2012.

The factors that might support prices on the upside are largely geopolitical factors (at least in the near-term). Talking about specific support targets on the downside might be difficult in an economic environment where any 2008 like credit freeze can lead to collapse in all asset classes. However, I personally don’t see such a calamity for the asset markets.

Given the way the global economy is slowing down, a 25-30% correction in crude prices over the next 3-6 months is very much on the cards. I consider any such downside as an excellent opportunity to consider exposure to black gold for long-term. My rationale for long-term exposure to crude is explained in one of my earlier articles.

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