Oil turns bullish on dollar and equity support

“You cannot escape the responsibility of tomorrow by evading it today.”

Abraham Lincoln

Oil prices are hovering in negative territory in overnight trading even as global equities are continuing to firm and the US dollar is trading either side of unchanged. Last night’s API oil inventory report was bearish for crude oil but bullish for gasoline and supportive for distillate fuel (see more details below). The combination of the unreliability of the API data and the fact that the financials have been the primary driver of oil and other commodity prices has negated any overreaction to last night’s API inventory report as the market awaits this morning more widely followed EIA report. Although oil prices are toppy based on current fundamentals market participants are more focused on the perception trade or what the fundamentals might be down the road. Many analysts are starting to project a more balanced supply and demand profile as we move into 2011 as demand from the emerging world continues to grow (especially China) while the developed world remains mostly flat. Next week we will get the EIA, IEA and OPEC updates of their monthly long term forecasts.

Oil prices have increased by almost 14% since bottoming around the middle of September...mostly based on the weakness of the US dollar and the firming equity markets. As shown in the following chart of the spot Nymex WTI contract versus the US dollar index and the S&P 500 equity index the correlations remain very high with no sign of any decoupling at this phase of the trend. The market is starting to buy into the scenario that irrespective of where the economy heads from here, it is likely to be supportive for oil and the broader commodity complex. If the pace of the global economic recovery picks up in both the developed and emerging world demand for oil will increase and accelerate the return to a more normal historical supply, demand and inventory relationship which would be a supportive scenario for prices. If the economic recovery stalls or just moves very slowly (as of the moment) we can expect more quantitative easing coming from the US (we already saw it in Japan this week) which would not only help to put a floor on the recovery but would result in the US dollar remaining under pressure increasing the risk of inflation which in turn would be supportive for oil prices. At the moment the market is looking at both scenarios and feeling more and more comfortable about being long oil and pretty much most any traditional commodity, including gold. The risk asset trade is back in the forefront.

Not only did commodities surge yesterday (including gold making yet another new record high) but global equities also surged higher with buying continuing in overnight trading as shown in the EMI Global Equity Index table below. Over the last twenty four hours every bourse in the Index gained ground as shown in the table below. The Index is solidly in positive territory and at the highest level since the first half of April. The Index is higher by 2.5% for the year to date with Canada (a resource/commodity driven economy) still holding the top spot on the leader board. Six of the ten bourses are in the winners column with China’s Shanghai A shares still hovering below the bear market threshold for the year. Most Asian markets gained ground overnight while Europe is also starting the day in positive territory. The main storyline in the financials is still the falling US dollar. The dollar is currently below the last major support level and losing ground on a negative view of the US economic recovery coming from trader/investors as they focus on recent Fed statements. The US dollar has given back most all of its gains from earlier in the year (especially those occurring during the peak of the EU debt crisis) and is currently trading at the same level it was at back in mid-January of this year. Simply put equities and the US dollar remain strongly supportive for oil prices.

Yesterday afternoon the API released a mixed inventory report showing a surprisingly larger than expected crude oil inventory build of 4.4 million barrels along with a surprisingly larger than expected decline in gasoline stocks of 4.1 million barrels while distillate fuel stocks were within the expectation for a draw of around 800,000 barrels. The results of the API report are summarized in the following table along with my projections for this week’s inventory report and a comparison to last year as well as the five year average for the same week. So far, the market has pretty much not reacted to the API report as oil prices are mostly lower across the board. Of interest, the API data also showed builds in both PADD 2 and Cushing suggesting that the current strengthening of the WTI/Brent spread may be coming to an end as refiners cut back utilization rates (API runs declined by 2%). As a precaution, I closed my long WTI/Brent spread last night while I await this morning’s EIA data for more clarity.

My projections for this week’s inventory report are summarized in the abovetable along with a comparison to last year as well as to the five year average for the same week. I am expecting a mixed report with a minor build in crude oil (as a result of refinery utilization rates declining) and modest draws in both gasoline and distillate fuel. If the actual numbers are in sync with my projections for a crude oil build of 600,000 barrels it would raise a question mark about the early start of a destocking trend in crude oil seen over the last few weeks. However, the declines to date have not had any significant impact on the overhang that has persisted in the US throughout the entire economic recovery so far. As such, I would categorize crude oil as biased to the bearish side as the year over year surplus will still be around 21.1 million barrels while the overhang versus the five year average for the same week will have in fact widened modestly to 39.8 million barrels.