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In 2009, oil was driven by one primary factor, the U.S. dollar.  As the dollar weakened, those global commodities that were priced in U.S. dollars strengthened, namely oil and copper.  We measured this inverse correlation at almost 4.5:1.  Time will tell whether this relationship holds for 2010, but it is likely safe to assume any major move in the dollar will continue to impact oil in a similar manner.

Obviously, the price of oil is a critical component to any sustained consumer spending recovery.  The dramatic decline in oil in early 2009, on a year-over-year basis, was a key component of our theme, the MEGA squeeze, which played out in the first half of 2009 as the key components of consumer spending improved leading to a major short squeeze in consumer discretionary stocks.  Gasoline pricing in the back half of 2009 was incredibly stable, which is likely the best case scenario for consumers as one can plan their spending with a stable input.  From July 2009 to December 2009, gasoline was in a range of $2.46 to $2.69, which if sustained into 2010 would be a positive scenario for consumers.

Fundamentally as it relates to oil supply and demand, incremental growth in global GDP will lead to incremental growth in global oil demand, which should tighten the global oil market.  The inventory balance in the U.S. over the past 4-weeks may be foreshadowing a tighter supply and demand picture globally in 2010.  Inventory has fallen from 339MM barrels to 327MM barrels and days of supply has fallen in the same vein from 24.5 to 23.7.  While inventory levels are still slighly above their 5-year range, they are only marginally above that range.

Two weeks ago, the Department of Energy highlighted a key point as it relates to supply in their weekly statistical note, This Week In Petroleum.   According to the DOE:

"The majors’ upstream capital expenditures declined relative to Q308 but by much less than the fall in net income, and were about equal to the third quarter average for 2004-2008. In particular, worldwide oil and gas production capital expenditures fell 35 percent relative to Q308 and by a much smaller 1 percent relative to the third quarter average for 2004-2008."

Interestingly, according to this analysis, while capital expenditures for the world's major oil companies was down dramatically from 2008, in aggregate it was at a comparable level to the prior 5-years.  The implication of this is likely that while the oil price was volatile in 2009, companies continued to spend on exploration and development of future oil reserves, which is a signal that these major producers still believe supply in the future will be tight.

As the article goes on to note, despite this year-over-year drop off in capital expenditures, production is still growing:

"Notwithstanding the reduction in capital expenditures, oil and natural gas production in Q309 continued to show growth. In each of this year’s quarters (Q109, Q209, and Q309) the reporting companies’ aggregate domestic oil production, foreign oil production, domestic natural gas production, and foreign natural gas production all increased over the comparable quarter in the prior year and are the only quarters in which this has happened since Q401. Further, domestic and foreign oil and gas production in Q309 all exceeded the third-quarter average over the previous five years. The increases in production, despite the sharp drop in capital expenditures, resulted from the lagged effects of higher capital expenditures in earlier periods."

While the U.S. dollar will likely continue to drive the price of oil for the forseeable future, as oil comes back into balance on the demand side and the reduced capital expenditures in 2009 have some, even if muted, impact on supply, it seems likely that supply and demand data points become more important for the price of oil in 2010.

Daryl G. Jones

Managing Director