Quote of the Day
Logic will get you from A to B. Imagination will take you everywhere.
Albert Einstein
Iran, Iran and a little bit more Iran has been the main price driver pushing Brent and WTI price to the highest level since May of 2011 when the Libyan civil war was in full swing. Geopolitics drove prices higher in early 2011 and geopolitics are once again driving prices higher in 2012. Tensions rose again yesterday when Iran refused to let the UN IAEA inspectors visit Iran's nuclear sites resulting in this round of inspections and meetings to be deemed a failure. Certainly the actions by Iran yesterday raises concern that Iran has something to hide and what they are hiding might possibly be work toward developing nuclear weapons. The UN communiqué said that there was still no agreement on how to begin the clarification of unresolved issues in connection with Iran's nuclear program, particularly those relating to possible military dimensions. So the tensions continue to rise and the price of oil is continuing to follow higher with each event evolving from the region. Although there have been several conciliatory signals, like the Iranian letter calling for a meeting with the west, the situation between Iran and the west is not getting any better and in fact is deteriorating even further.
The US and European stance is to continue to allow sanctions to work...which they seem to be impacting Iran. That said even if Iran has lost sales of oil and its exports are down (difficult to get a number on this) the price of oil is clearly higher. Since the European's issued their embargo on Iranian crude oil purchases, the price of Brent has risen about $10/bbl and thus Iran's revenue stream is likely to be where it was before the embargo (assuming some lost crude oil sales) or possibly higher if their export volume is still holding. Thus the sanctions may not be having much of an impact on Iran at this point. That does now mean they will not have an impact. However, will the Israelis be willing to wait and see if the sanctions do impact Iran and ultimately serve to change their stance or will Israel's patience run out and result in military action. That is by far the biggest wildcard in this whole situation.
So far there is no shortage of oil from anything going on in the Middle East and all of the price gains can be categorized as a risk premium that is widening as the market views the situation as one that could eventually lead to a supply disruption. Certainly if there is military action taken by the Israeli's or preemptively by the Iranians' there will be a supply disruption that is difficult to quantify as well as to determine how long it would last. Simply put if that were the outcome the price of oil would surge to new all-time highs and likely exceed the highs made back in July of 2008. This scenario is the main risk in the oil market and a risk that would not only send oil prices surging but it would have a significant impact on the precarious growth rate of the global economy. Hopefully this is simply a scenario and not one that actually turns out to be a reality.
That all said even with a modest risk premium growing into the price of oil, it may not yet be impacting Iran but it is slowly starting to impact the consuming world economies as inflation risk is rising and the cost of doing business is rising every day. As oil prices continue to rise the likelihood of both the developed and emerging market economies will continue to slow down. Even without a military conflict in the Middle East rising tensions and thus rising oil prices are and will continue to have a negative impact on the global economy...that is the real risk at the moment.
Today the HSBC manufacturing index (PMI) for China came in at 49.7 ...a bit better than the previous month but still below the 50 threshold that suggests manufacturing activity is contracting. In the Eurozone, the services and manufacturing indices both suggested further contraction. Just another signal that the global economies are still growing at a very slow pace and may be contracting even further...especially if oil prices continue to rise.
Of interest, the drivers that have been principally moving oil prices up and down over the last several years are continuing to transition. The following two tables (which have been updated through yesterday) show the daily correlations (over various timeframes) between WTI & Brent versus the normal external price drivers that have been in place for the last few years. The first table shows the correlations between WTI & the US dollar, euro and S&P. The analysis shows the evolution of the correlation from one year to the last 30 days. Going back over the last year the relationship between the price of oil and the US Dollar Index has clearly been in an inverse relationship while the euro has been directionally correlated. Both of these correlations to the currency markets for the one year timeframe have been modest while the relation of WTI versus the equity market (basis the S&P Index) has been a relatively strong directional correlation.
Interestingly as we move the time horizon closer in the correlations have been changing. Each shorter period shown has resulted in the correlations becoming less correlated to the price of oil and thus less of a significant price driver for oil. In fact the inverse relationship that has existed with the US dollar has now reversed and is showing a small positive correlation. On the other hand the euro has switched from a directional relationship to a small negative correlation. The correlation between WTI & the S&P Index has not reversed but the strength of the correlation has weakened considerably.
The second chart of Brent crude oil compared to the same currencies and the S&P Index has evolved much the same as WTI but not to the magnitude as WTI. The currency correlations actually did not reverse until we look at the last 30 days (average). Interestingly the relationship between Brent and the S&P Index has not varied all that much and the last thirty days is showing the same correlation level as the one year correlations.
What does all of this suggest? First the relationships between WTI and the external price drivers, and Brent and the external price drivers has been impacted by all of the reasons why Brent has been trading at a premium over WTI...surplus inventories in the mid-west area of the US, loss of Libya, potential impact from the embargo of Iranian oil purchases by the EU and a few others. Simply put the market price of oil has been more reflective of what Brent has done over the last year (or more) than how WTI has traded. Based on the 30-day correlations, Brent is still being driven mostly by the macros while WTI is being driven more by fundamentals and geopolitics.
The second and possibly the more important conclusion from this brief analysis is the fact that the external price drivers that have been strongly in place for several years are starting to change...change coming faster versus WTI a bit slower versus Brent. The changing relationship is suggesting that the normal internal price drivers...principally fundamentals are starting to impact the day to day direction of oil prices more today than a year ago. With Europe potentially moving to the background the macro drivers may become less relevant insofar as the day to day direction of oil prices are concerned. Change is in the works and looking more closely as short, medium and long term oil fundamentals (and technical analysis of the oil complex) are likely to be more relevant in projecting the oil price than has been the case and thus likely to be more closely followed by the trading community once again.
Interestingly global equity markets have been able to hold onto the majority of their gains for 2012 so far in spite of the global turmoil. As shown in the EMI Global Equity Index table below the Index is higher by 13.3%. Hong Kong, Brazil and Germany are holding the top three spots in the Index. With inflation risk rising and economic growth looking more and more like it is slowing the global equity markets are becoming more and more susceptible to a modest round of profit taking selling.
This week's oil inventory reports will be released a day late because of the holiday in the US on Monday. The API data will be released on Wednesday afternoon while the EIA data will hit the media airwaves at 11:00 AM EST on Thursday. At the moment oil prices are still being mostly driven by the tensions evolving in the Middle East between Iran and the West (as discussed above) and to a much lesser extent based on the direction of the euro and the US dollar. As such I am not sure many market participants are going to pay much attention to this week's round of oil inventory data suggesting that this week's oil inventory reports may not have a major impact on price direction. At the moment all market participants are continuing to follow the new snippets out of the Middle East and the tick by tick direction of equities and the US dollar (driven by Europe)...as they are both the primary price drivers for oil. Even with the fundamentals and geopolitics starting to impact price, it is the macro trade that dominates at the moment. As such this week's oil inventory report could remain a secondary price driver at best and only impact price direction if the actual EIA data is noticeably outside of the range of market expectations for the report.
My projections for this week’s inventory reports are summarized in the following table. I am expecting an across the board draw in inventories this week with a modest decline in crude oil and gasoline stocks, a seasonal decline in distillate stocks along with a small decrease in refinery utilization rates. I am expecting a small draw in gasoline inventories and a seasonal draw in distillate fuel stocks as winter like weather did arrive for part of the report period in some parts of the US...in particular the east coast. I am expecting crude oil stocks to decrease by about 1.5 million barrels. If the actual numbers are in sync with my projections the year over year deficit of crude oil will come in around 9.2 million barrels while the overhang versus the five year average for the same week will narrow to around 3.9 million barrels.
With refinery runs expected to decrease by 0.2% I am still expecting a modest draw in gasoline stocks. Gasoline stocks are expected to decrease by about 0.9 million barrels which would result in the gasoline year over year deficit coming in around 7 million barrels while the surplus versus the five year average for the same week will come in around 3.8 million barrels.
Distillate fuel is projected to decrease by 1.5 million barrels on a combination of an increase in exports and a bit of winter like weather last week. If the actual EIA data is in sync with my distillate fuel projection inventories versus last year will likely now be about 17.7 million barrels below last year while the surplus versus the five year average will come in around 1.2 million barrels.
The following table compares my projections for this week's report (for the categories I am making projections) with the change in inventories for the same period last year. As you can see from the table last year for the same week was mostly in the same direction as the projections except for crude oil. As such if the actual data in line with the projections there will not be a major change in the year over year comparisons for most everything in the complex except for crude oil inventories.
WTI is now trading above its most recent resistance level of $104/bbl (now a support level with $110/bbl the next level of resistance. Brent has also breached its resistance level of $120/bbl yesterday. But as with WTI... Brent is also settling into a new short term trading range of around $119/bbl to $126/bbl. Oil continues to be driven by the evolving geopolitics of the Mideast...in particular Iran with just about all of the other normal prices drivers taking a secondary role...including fundamentals. I am keeping my view at cautiously bullish and keeping the caution flag flying to remind all that the market is still susceptible to a modest round of profit taking selling in the short term.
I am still keeping my view at neutral and bias at bearish as once again there is not much supportive indications that Nat Gas is likely to embark on a major short covering rally anytime soon. The surplus is still building in inventory versus both last year and the five year average is going to get harder and harder to work off even it gets cold over a major portion of the US and as such for the medium to longer term I am still very skeptical as to whether NG will be able to muster a sustained upside rally over and above a short covering rally.
Currently markets are mostly lower as shown in the following table.
Dominick A Chirichella
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