Despite surging domestic U.S. oil production and multiyear highs in inventories, WTI crude oil continues to be one of the most resilient commodities on the market. After falling to $92.67 this past Monday, WTI crude oil has rallied all week, currently trading at $97.20.
Below is the year to date performance across the futures market.
This resilience in WTI crude oil has been amongst relative calm, with the CBOE Crude Oil Volatility Index (OVX) continuing to trend downwards. In addition, the recent spike was one of the smallest all year, barely registering by historical standards.
I believe this calm is bound for a correction, especially if oil inventories continue to build over July and August.
The Past Relationship between Crude Oil Inventories and WTI Crude Oil's Price
Below is a chart of the past 23 years comparing WTI crude oil and US Crude Oil and Petroleum Products Ending Stock Excluding Strategic Petroleum Reserves. The long time frame is to provide context to current inventory levels, as well as the relationship between inventory levels and WTI crude oil's price. The shaded grey areas are U.S. recessions.
There are two key takeaways from this long term chart. First, U.S. oil inventories have been climbing since March of 2003. Second, so have oil prices.
Therefore, rising inventories do not in and of themselves push oil prices lower. Another catalyst is required for oil prices to break below $90.
Going from a longer term to a shorter term view, the past 5 years also provides interesting insights. Below is the same chart on a 5 year basis with the S&P500 index included.
Besides oil prices rising with inventories, similar to the longer term chart, the robust relationship between the SPY and WTI crude oil is demonstrated. This relationship began to breakdown in May 2012. WTI crude inventories after May 2012, rather than fall as they did in 2009, 2010 and 2011, held steady. This lack of depletion of inventories caused WTI crude to trade below $90 from October 2012 to January 2013.
I believe much of the long positioning by large speculators as per the Commitment of Traders Report (COT) in WTI crude oil is based on the historic correlation between SPY and WTI crude oil. Many of these large speculators will run financial models and algorithms based on this historic correlation, and the rally in the SPY would cause models to recommend a buy on WTI crude oil. The last COT reported extreme long positioning by large speculators.
The question is, why didn't oil inventories fall in the winter of 2012, and will they in the winter of 2013?
China's Oil Consumption
I believe oil prices rising while inventories were rising can largely be explained in one word, China. While the U.S. percentage change in oil consumption from 1990 to the end of 2011 had risen only 9.22%, China's oil consumption had risen 340%.
Therefore, if there is a broader slowdown in China, there will be a fall in oil consumption. Essentially, a short crude oil position is a quasi-short on China's growth. According to the HSBC PMI numbers and Shanghai stock index, growth in China is a very real concern.
US Oil Production
As much as Vladimir Putin and others attempt to downplay the shale revolution, it is here, and it matters. U.S. oil production is at levels not seen since 1991 and is growing exponentially. As the shale oil revolution expands, there is a very real possibility that U.S. oil production surpasses the peak it reached in the 1970s.
U.S. production is currently at levels which, when they were last seen, resulted in oil prices under $25 per barrel. Of course, the rising prosperity of China and other countries, as well as the higher production costs of shale oil, make it unlikely oil prices will reach that level again. But the run up that began in 2002 is definitely in peril.
The Catalyst for Lower Oil
The softening demand in China with the rising production in the U.S. makes for huge downside risks in WTI crude oil prices. When will this be reflected in market prices or the investment hypothesis be falsified?
I believe this question will be answered in the coming months with oil inventories. Contrary to 2009, 2010 and 2011 when oil inventories fell going into winter, I am expecting similar behavior of inventories as was seen in the last half of 2012, which led to oil prices falling below $90 per barrel.
The big difference between 2012 and now is that crude inventories are already much higher than they were going into winter. EIA data just this past week surprised to the upside, with a buildup rather than a fall in crude inventories.
When oil inventories fail to fall this July, August and September, the realities of supply and demand will set in and crude oil prices will begin to fall. This fall in prices will cause large speculators to re-evaluate past correlations, creating potential momentum to the downside. The extreme long positions by large speculators combined with the extreme WTI crude oil inventory levels could create price action much like that which is being seen in gold right now.
Watch oil inventories and growth in China over July and August. If oil inventories continue to build and the situation in China does not improve, look for WTI crude oil to fall below $90 per barrel, maybe more.
Disclosure: I am short USO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am actively trading FOREX and CFDs and may either be long or short the instruments discussed at the time of this article's publication. To see a complete list of my open trades in real time, visit mcnultycapitalmanagement.com.