The market in general has taken a bit of a breath as the issues that seemed to be driving the price discovery of the past several weeks have seemingly subsided in the collective mindset with stability for now in China, the fine print on the Greek deal on the verge of being executed and the slide in energy commodities finding support. The WTI crude stopped its recent downturn after finding support in the 45 dollar range though any follow through rally has yet to manifest itself. There are several questions to answer in an effort to figure out the fundamental direction going forward.
First; can demand support higher prices? The answer to this is obviously complex in the global trading sphere in which we now exist. Demand question are warranted in China with declining economic indicators leading many to believe that the second largest economy in the world is slowing at a rapid pace. While Chinese growth has slowed from the hyper inflated low teen GDP numbers everyone became accustomed to, it is still growing at a very healthy 7+% rate. The crisis in Europe appears to have been averted for now, though it does seem to rear its ugly head every year or so, leaving everyone with a certain lack of confidence in the back of one’s mind. However, here in the US, we are currently prepared to embrace a tightening bias from a rate perspective looking forward to what could be a substantial new trend toward rate normalization. This is certainly a very different direction than what the rest of the globe, as illustrated above, is faced with. Couple that with the near record demand for refined products stateside, particularly gasoline, and I think that we can answer definitively that, at least here in the US, demand can support higher prices.
We can look for further evidence of this dichotomy of the global economic strength and/or weakness by looking to the WTI-Brent crude spread. Prior to the most recent sell off, the differential was at about $6.50 Brent over WTI. Currently it sits at or around 4 dollars. I think that this is the strongest evidence that the WTI contract based on US demand is healthier for the long run as most of the bearish developments of late are specific to the Brent rather than the WTI (Iran, China, Europe, etc.).
Second; is the world really overflowing with Crude? There is certainly more crude available than ever in history. That doesn’t serve to properly answer the question though as the demand for crude and the refined products have potential to keep up with that supply, thus making the result of more crude less of an issue than some would have you believe. For example, even with OPEC pumping at record volumes, the Saudis are now keeping more crude in country than ever before as they have exponentially ramped up their refining capabilities due to the higher demand for those products. In the US, the rigs counts have started coming back on line yet the inventory numbers continue to show modest declines in stocks week after week (see yesterday’s decline in API).
Third; is the price discovery of the futures markets a fair analysis of the relative value of crude? The value of something is essentially defined by what someone is willing to sell something for versus what someone is willing to buy that same product for. However, in the futures markets, particularly with crude oil, there is a tendency to overdo fundamental moves as market participants are seeking something other than buying or selling a product (i.e. looking to see how far a market can go down or up before support or resistance kicks in, market participants seeking out risk parameters, gravitation toward particular strikes at expirations, etc). What is for certain is that when the reversal occurs in a market of this nature, the rubber band effect can and usually is substantial, particularly when egregiously oversold.
As the price of any commodity declines, the bears will come out of the wood work and look for after the fact justification for said sell off. I continue to see all sell offs as buying opportunities, particularly in the crude in the mid 40's. However, the irrational market has a tendency to remain so longer than we can expect or anticipate, making proper trade development with an eye to appropriate risk even more important than usual.
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