Oil Prices Reflect Continuing Market Overreaction

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 |  About: The United States Oil ETF, LP (USO)
by: Kent Moors

After another pricing pullback of almost 10%, crude oil prices rebounded yesterday on the back of an unlikely source: A Spanish deputy prime minister presented a budget.

The proposal was hardly earth shattering. It detailed planned expenditure cuts but provided no details on the other shoe that has to fall -- tax increases. Given that a main element in the European crisis continues to be on the fiscal side, tax increases will have to follow.

The difference cannot be made up only from program cuts. The budget announcement, therefore, appears simply to forestall the inevitable.

Nonetheless, a dry news conference in Madrid was the latest excuse for bulls to take over and drive the oil price (and the markets) higher.

This is merely the latest example of an immediate overreaction to developments. Yes, it is important that Spain is positioning itself to benefit from the new paper buyout plans being orchestrated by the European Central Bank (ECB). Unlike the basket case that is Greece, Spain made an effort to clean up its act prior to a bailout request.

Next up (unless we have another "siesta pause" from the authorities in Madrid like the one that delayed the budget announcement) are the stress test results of Spanish banks. The detractors are lining up already to dispute whatever results are released. And there is some question over whether the test is a valid indicator of overall banking sector weakness.

However, there is no doubt what the government’s objective is. This will not be an across-the-board rescue of the banking sector because Madrid does not want a full-blown rescue from the EIB. That would put the entire Spanish banking industry under pan-European oversight. Now, it may ultimately come to that. But before officials capitulate, they will orchestrate a smaller number of comparatively healthier financial institutions (at least on paper).

This hardly ends the crisis. But it does indicate that a strategy is taking shape. And that is all the bulls needed to charge forward.

Volatility Is the Real Story

Today we have a combination of short-term profit taking and some disappointing U.S. manufacturing figures contributing to move markets lower. The yo-yo effect marches on, with the immediate reading of events pushing the market in one direction or the other. Volatility is now as much a result of headline reading as it is the result of genuine indicators.

Which brings us back to oil.

With the exception of short artists and a few pundits ignoring the fundamentals, the overwhelming prognosis is for a rise in prices. As I noted last week from London, the broad-based assumptions in Europe call for accelerating crude oil levels, made all the more significant by the prospect of a worsening geopolitical picture.

In addition, the moves by central banks to add liquidity will have a direct upward impact on oil prices. This has already happened before the Fed has actually purchased any of the $40 billion per month it has pledged in mortgage paper buys with no limit in sight.

Market watchers are now waiting to see what China does. It is widely anticipated that an announcement is coming soon on quantitative easing Beijing-style to offset a cooling off period in Chinese economic expansion. That will be enough to spur the next rise.

All of this is because markets on both sides of the Atlantic have decided to equate the oil pricing base with projected demand levels. Now, I have mentioned several times before the shortcomings of this approach.

For one thing, genuine demand levels can only be estimated quarterly (if then), not weekly as is the common practice among pundits after each Wednesday’s EIA figures are released. For another, while analysts will look at trends, the talking heads on TV will usually react to a figure or a riot and immediately sketch any number of scenarios better left for a miniseries screenwriter.

For yet another, the demand projections instantly sketched are usually way off when the actual data come in. Increases in stockpiles are equated to declines in demand, despite there being no tangible basis for so doing.

Here's How They Got it Wrong

For example, the most recent slide in prices was augmented by the report of a major increase in inventory. The sages then equated that to collapsing demand, and the price declined straight away.

Turns out much of this stockpiling was a result of increasing imports completed before an anticipated new round of price increases. In other words, processors were not reacting to current demand levels at all. Instead, they were positioning themselves for improving refinery margins (and increasing profitability). A quick scan of major U.S. refiners will show that is already coming into play.

The rapid rise in gasoline futures prices over the past two days is another clear indication of what the real reason behind the inventory increase was. If demand is actually going down, the price would be moving rapidly in the other direction.

We will continue to wrestle with knee-jerk comments from "experts" and corresponding market overreactions because the "new normal" for oil is actually a very volatile one, accentuated by sound bites. None of this makes any genuine difference to the near-term view.

Overall, despite declines along the way, oil pricing is going up and there is nothing the short artists can do about it -- aside from causing a few bumps along the way.

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Disclosure: None.