Oil corrects amid small inventory build

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E.M. Kelly

The downside correction in oil prices continued for a second day on Tuesday but has stabilized so far in overnight trading. I am not sure this is the end of the correction but if it turns out to be it will have proved to be shallow and short as I have been suggesting over the last several days. Oil is being driven by two main catalysts in my view...first and foremost by the ongoing geopolitical risk in the Middle East and Africa...especially Iran. The second driver is the massive amount of liquidity the Central Banks have been and continue to put in the market in variations of quantitative easing. Neither of these price catalyst are going to disappear anytime soon and as such I still expect oil prices to experience shallow and short duration downside corrections like we have seen (so far) with the correction that has occurred this week. Both of these price drivers are acting as a so called "Put" in the market and will prevent prices from declining precipitously until it becomes clear that either one or both of them have begun to disappear.

Speaking of liquidity, the European version of TARP, called LTRO, announced that the European Central Bank's massive loan program to the banks was higher than expected at about $713 billion USD (€529.5 billion). The loans were three years in duration at record low interest rates. 800 banks took advantage of the cheap money versus the last round of funding offered by the LTRO program. The markets have viewed the outcome of the LTRO as a positive for most risk asset classes...especially European equities. As each week goes by the market is placing less and less risk on the Eurozone region as the sovereign debt risk moves toward the background and market participants are focusing more on normal price drivers for global risk assets and less on catastrophic event risk that had engulfed most of the markets for the majority of last year. Also as discussed above with billions of dollars of funds continuing to be periodically injected into the global economy along with the perception that more may be coming (via a possibility for a QE3 from the US Central Bank) is very supportive for most risk asset classes including oil...the liquidity or soon to be inflation "Put".

With the developed world economies doing all they can to inflate their way out of the malaise that has engulfed these economies along with the potential for more stimulus like programs and a switching to more accommodative monetary policies in the developing world it is looking like risk asset markets...both equities and commodities are poised to continue in the uptrend that has been in place for the majority of this year. I am not saying that these markets are only going to go higher rather I am suggesting that we are in an uptrend that will experience downside corrections from time to time but when the dust settles at the end of 2012 all of the current signs and signals (that are in view at the moment) suggest that most risk assets values will be higher or above where they were at the end of 2011..incluidng oil. How much higher is a whole different issue that I can honestly say I have no way of forecasting but I do currently believe that they will be higher.

Oil is a bit different than most of the other risk asset classes in that is has a second catalyst impacting its price...geopolitics or better said the possibility for an interruption in the supply of crude oil due to unpredictable events in areas where the majority of the crude oil is produced and exported from. Absent these evolving risk zones the price of oil would be lower than it is at the moment but still clearly in an uptrend like most of the other risk asset classes. The last $10 to $15/bbl (WTI or Brent) of risk premium that has been embedded in the price oil came about after the EU announced their embargo on Iranian crude oil purchases raising the stakes in an already high stake game of "Middle East Hold-em oil poker." As I have mentioned on many occasions there is no shortage of oil anywhere in the world due to Iran. The market is trading on a perception that a supply interruption may occur at some point in time in the future.

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