Oil hanging on Iranian geopolitical factors

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.

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