From the October 01, 2009 issue of Futures Magazine • Subscribe!

Energy outlook: Crude correlations and what comes next

Want to know where crude oil is headed? Look no further than George Washington, Dow Jones and the S&P 500. In this new world of economic chaos, supply/demand factors and geopolitics have shifted to the back burner as crude becomes more heavily linked to the U.S. dollar and the stock market. At the end of August 2009, crude was in the $70 range, twice its February 2009 levels.

Crude has a positive correlation to equities and an inverse relationship to the dollar — when the dollar is weak, crude tends to go higher (see “It’s not that complicated”). Analysts say current dollar weakness and stronger equity markets have contributed to higher crude prices and should be the main movers of crude through the end of 2009.

“The overriding factor right now [for crude oil] is the state of the global economy,” says Linda Rafield, senior oil analyst at Platts. “Throughout 2009, the oil markets have been looking at the price of equity markets and the U.S. dollar, taking their cue from the financial sector rather than from supply/demand balances in the oil markets. Dollar weakness has fed into the rebound in oil prices.”

Dominick Chirichella, founder of the Energy Management Institute, says that equities and currencies have put oil in an uptrend going back to mid-March of 2009. He expects the dollar to remain weak the rest of the year and equities to stay firm, which will put a floor under the price of oil.

Dave Chatterton, vice president at RJO Financial, says the dollar and crude will continue to show an inverse correlation. “The question is, is the dollar going to bottom out at any point soon and become bearish to the energy complex? I think it will. Between now and the end of the year, crude prices are going to be sideways to lower. In the dollar, it’s going to find a bottom and come off of those lows,” he says.

Heavy stockpiles of crude show that supply is not a huge concern right now. “In the U.S., our stockpiles are well above the five-year average and we’re close to 18-year highs in our supplies of crude oil. The driving factor is the outlook for growth and the falling value of the U.S. dollar,” says Thomas Hartmann, analyst at Altavest Worldwide Trading.

“For now, the fundamental supply and demand factors of the underlying complex are taking a backseat to views on the economy or what economic activity is going to be in the third and fourth quarter of the year and the first half of 2010,” Chatterton says. “Stocks are at near-record levels. Even if we had a hurricane, we’ve got so much gas that it’s not an issue at this point. You could make the argument that by this time next year we could be in a tighter [supply] situation, but to make that argument you have to believe that the economy is going to recover and actually grow next year, and that’s a pretty dangerous assumption.”

Rice University’s James Baker III Institute for Public Policy has a different take on the clear negative correlation of crude and the dollar. A study they conducted suggests that the increase in long non-commercial interest in crude oil fueled a rise in prices, which in turn created dollar weakness. That dollar weakness in turn pushed crude oil higher, creating a vicious circle. The study notes that there was little correlation between the dollar and crude oil from 1986-2000. This is an interesting notion, but there are quite a few other variables that need to be considered. The theory that speculation from index funds was the main driver for the price of crude oil may be tested as the Commodity Futures Trading Commission appears ready to place limits on speculation and has already pulled the exemptions to position limits on some commodity-based funds.

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