Conclusion: While we are bearish on the fundamentals for oil, the downward pressure on the U.S. dollar is supporting the price of oil -- so it remains in no man’s land from an investment perspective.
We’ve been noticeably quiet lately on oil, which is atypical for us on any topic.
All joking aside, we’ve been quiet on oil because we don’t have a conviction view at the moment, though fundamentally we are negative for three primary reasons: supply, lack of U.S. dollar correlation, and slowing U.S. growth.
- Supply – As we’ve outlined in the chart below, U.S. stocks of crude oil are well above their five year range. In fact, there are currently 360.8 million barrels of crude in storage in the United States, which is 23.4 days of supply. This is an increase of 4% over 2009 supply numbers from the same period. In addition, supply has been increasing steadily since the start of July. Despite this, the price of oil is actually up almost 18% on a year-over-year basis for the same period. (As a side note, oil production domestically is up almost 8% year-over-year to 5.4 million barrels, which is not a fact commonly bandied about.)
- U.S. dollar correlation - In 2009, the key macro factor driving the reflation trade was U.S. dollar down, and everything priced in U.S. dollars up. Simply, the decline in value of the U.S. dollar versus other currencies increased the inherent value of those global commodities that were priced in U.S. dollars. Oil was a primary beneficiary as its price increased by almost 80%. The correlation, or at least the strength of it, is no longer intact. In fact, since late June we have seen a dramatic decline in the U.S. dollar versus other major currencies, north of 7%, but have not seen a similar move in oil. In 2009, oil moved inversely to the dollar with a factor of more than 4:1. As noted, recently that correlation has gone away, so despite being bearish on the dollar, we are not seeing a corresponding correlation that makes us bullish on oil.
- Sequentially slowing U.S. growth – Early next week, during our August theme call, we will get into this in greater detail, but we believe that growth next year in the U.S. will be half that of consensus expectations. This will be driven by the likely need for austerity measures and continued Housing Headwinds. The United States consumes ~24% of the world’s oil, so any change in the direction of U.S. economic growth will have an impact on global demand, and thus pricing. This is further emphasized by the fact that the U.S. imports ~61% of its oil so is an even larger percentage of the export market with a commensurate impact on market prices.
Yesterday, the EIA reported supply information that was touched on above, that highlighted the anemic demand environment. Specifically, consensus estimates were for an increase in supply of 2.3 million barrels, while the actual number came in at an increase of 7.3 million barrels week-over-week.
The wild card to the bearish scenario outlined above will be Chinese demand. We have been quite vocal in our Chinese Ox in a Box thesis on China this year as we have seen the government take steps to slow down economic growth to head off inflation. As of June, China was consuming 8.99 million barrels per day, which is up 10% from a year ago levels. Any acceleration in Chinese economic growth, would offset some or all of the decline in U.S. demand due to sequentially slowing economic growth.
Longer term, the potential thirst for oil from China is substantial. According to recent analysis from Platt’s:
“In any event, without delving deeper, we might expect China's steady state demand for oil could prove not less than that of more advanced Asian nations. Based on the experience of Korea and Japan, China's current population would be expected to consume approximately 55 million barrels per day at steady state (when per capita consumption plateaus), or nearly 2/3 of current global oil production, were the supply available.”
In the short term we remain bearish on oil supply and demand, but in the longer term China’s thirst will trump all else.
Daryl G. Jones