The Weekly Report – Energy Mid-Year Recap (Crude Oil)

23 July 2012


In the last instalment, we looked at how natural gas fared between January and June 2012. While natural gas has certainly had a more volatile year, crude oil has also seen a lot of choppiness, as the markets contend with debt crises in Europe and slowing growth in China and the U.S. However, certain changes ahead could lead to a bump up in prices.

Source: Barchart

Source: Barchart

Source: Barchart

Source: Barchart

Unlike most ‘risk on’ assets — assets that have upside potential if the global economy normalizes or recovers — WTI crude oil did not begin the year with substantial positive momentum. This was due to uncertainty around the sovereign debt crisis in Europe, as well as a bit of a spike in U.S. crude oil inventories. Brent oil prices, which more closely correlate to macroeconomic supply and demand conditions globally, were less volatile during that same period, continuing the trend of disconnection between the world’s two major crude oil pricing benchmarks.

Brent spot prices, Year to Date

Source: YCharts

Source: YCharts

Both major benchmarks peaked within two weeks of each other, with WTI making its 2012 high at $109.77/barrel on February 24th and Brent reaching its highest level at $128.14/barrel on March 13th. The spread between WTI and Brent prices has also been very volatile but still remains far above the historical average at $15 as of July 13th.

Brent / WTI spread, Year to Date

Source: YCharts

Source: YCharts

U.S. crude oil inventories, Year to Date

Source: YCharts

Source: YCharts

Subsequently, prices have been on a long down trend.

Constantly increasing inventories in the U.S. put a damper on WTI prices. Additionally, while the year began on a high note as far as economic news, employment and consumption data in the U.S. suggest that the economy will be much more tepid, especially on the consumer side. This will ultimately affect crude as less people consume energy, and companies in turn stabilize or scale back production in order to maintain profitability.

WTI Crude Oil v US Dollar Index, Year to Date

Barchart

Barchart

Another interesting factor influencing WTI crude prices has been the emergence of the United States dollar as a safety currency, given the turmoil in Europe. While the correlation isn’t exactly one for one, new highs in the U.S. Dollar Index futures often coincide with or precede downside movement in crude. This makes sense, as crude is always purchased in U.S. dollars, and if it costs more to buy dollars in Euros or other currencies, that ultimately means the cost of crude goes up indirectly as well. This will ultimately decrease demand for crude, and prices in turn will adjust to a level where demand recovers.

Outside of the U.S., the European sovereign debt crisis continues to wreak havoc on investor and corporate confidence, and crude oil has not been spared. Since March there has been uncertainty around the crisis and the E.U. leadership’s handling of it, as well as the revelations of serious issues in the Spanish banking system in May through June; and these have all had major impacts on crude oil prices. During May and June it also became increasingly apparent that the Chinese economy is decelerating at a much faster and more dramatic pace than anticipated.

Implied volatility, as measured through options prices

 

Barchart

 

From the beginning of May through the end of June, WTI prices declined by 26% and Brent by 25% as investors retreated into ‘risk off’ territory due to the turmoil in Europe. Implied volatility or volatility as measured by trading activity in options markets, also increased notably during the May to June period.

However, there are several events which have reversed some of the losses in crude, and could potentially lead to a more sustained recovery in crude prices through the rest of the year. The turning point was the June 29th summit of European Union leaders, where the market perceived that the leadership turned a corner and displayed more resolve in dealing with the credit crisis.

Saudi Arabia also announced production cuts, and combined with the sanctions on Iran, and labour issues in Norway, supply could be curtailed in a very meaningful way, which would ultimately boost prices.

In the U.S., a major oil pipeline’s direction was reversed in order to facilitate more crude oil exports out of the Gulf Coast area. This will help ease the supply glut being experienced in that market, as the new crude producers will now be able to export to Asia and Latin America.

On the other hand, the most direct serious threat to crude prices is the slowdown in Chinese growth. As data in China deteriorates, policy measures become more drastic — some observers would say desperate. There have also been questions on the validity of some of the data points, specifically whether economic conditions are actually much worse than what is being portrayed in official figures.

However, as global growth appears to slow more and more, there is an increasing likelihood that a policy intervention in the three major global economic poles (the E.U., the U.S. and China) will occur as soon as the end of the third quarter.

Ultimately, this will help stabilize oil prices at the very least, and provide an environment in which stocks and bonds of well-managed oil companies will outperform their peers.

For more information on how you can benefit from these trends, contact me at michael.cooper@nullfirstlinesecurities.com or at 868-628-1175.

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