Oil's Opinion On The Likelihood Of A Global Recession

Includes: OIL, USO
by: Elliott Gue

Despite fears about a U.S. recession, a hard landing for China’s economy and the EU sovereign debt crisis escalating into a global credit crunch, the price of most oil varietals has remained stubbornly elevated. This resilience reflects tight supply-demand conditions in the global oil market.

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Source: Bloomberg

West Texas Intermediate (WTI) crude oil remains a deeply flawed benchmark of oil prices and global supply and demand conditions. WTI underpins the crude oil futures that trade on the New York Mercantile Exchange and has been the most widely watched benchmark for North American oil price for decades. Innumerable media outlets in the U.S. and Europe still quote WTI prices as the price of oil.

This inordinate focus on WTI made sense at one time. The U.S. has been the world’s largest oil consumer for more than a century; market conditions stateside had long served as a reasonable gauge of global supply and demand conditions. Moreover, as you can see in the graph, the price of WTI and other benchmarks of light, sweet crude oil prices have tracked each other closely in the past. Brent crude oil, a widely referenced international benchmark, historically has traded at a slight discount to WTI because this varietal of oil is of slightly inferior quality.

As I’ve noted on several occasions, this relationship has deteriorated to the point that a barrel of Brent crude oil in early September went for roughly $30 more than a barrel of WTI - a whopping 35% premium.

Despite its storied history as the go-to oil price, WTI clearly doesn’t reflect supply-demand conditions in the global oil market. Most international benchmarks for heavy, sour crude oil even command a premium to WTI. For example, Mexico’s Maya currently fetches about a $14 per barrel premium to WTI, compared to the heavy, sour varietal’s normal discount of $5 to $15 per barrel.

This anomalous relationship remains in force, though WTI has closed the gap slightly after rallying from its September low a bit faster than Brent crude oil.

Brent crude oil, which tells us everything we need to know about the supply-demand balance in global oil markets, trades at roughly $113 per barrel - up from $94 per barrel at the end of 2010 and about $80 per barrel 12 months ago. (WTI crude oil, which tells us everything we need to know about supply and demand conditions in Cushing, Okla., is roughly flat on a year-over-year basis.)

Readers often ask me why oil prices have rallied roughly 30% from year-ago levels amid concerns about weakness in the global economy and the threat of a global credit crunch.

At these levels, oil prices - and these three recent energy M&A deals - suggest that the odds of a recession or credit crisis are rather low. Meanwhile, equities markets have discounted a substantial economic downturn. Both markets can’t be correct: Either stock prices are too pessimistic about economic conditions or oil prices are too optimistic. I continue to believe that the former is true.

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