Crude Oil and the World Market
May has been an interesting month in the crude oil futures market. The crude oil market has sold off more than 25% of its value in the last month. It has gone from trading at over $90 per barrel down to $67 per barrel. The selloff has been based on two primary concerns; First, the continuing slowdown in Europe and secondly, the growing strength of the U.S. Dollar. However, commercial traders are betting that these concerns will be more than offset by continued growth in developing countries and declining domestic production through the politicizing of off shore drilling.
The European Union is going to face continued economic pressure as they deal with the after effects of their own credit bubble. We have written extensively about the troubles in Greece, “Pandora’s Grecian Riddle.” We also suggested that Greece would merely be the first European Union to succumb to the hubris of its own administration and that this would quickly be followed by Spain and Italy. An appropriate parallel is to the individual financial giants here in the U.S. as the government decided who lived and who died. For the purpose of understanding the selloff on crude oil, the important takeaway is one of simple human basic need. The countries in the European Union will experience a manufacturing slowdown. However, they will continue to cook, heat their homes, drive their cars and maintain the base needs of fully developed countries.
The growing strength of the U.S. Dollar has made crude oil cheaper because crude oil is traded on U.S. exchanges and priced in U.S. Dollars. Therefore, as the Dollar rallies, so does our purchasing power. However, since the beginning of May, the Dollar has only rallied about 7%. Obviously, this does not account for crude oil’s 25% decline. Of course, astute readers will recall that in February, when the Dollar rally began, crude oil experienced a 14% drop on a 4% rally in the Dollar. This created a selloff down to $70 per barrel before rallying back to $90. Therefore, the correlation remains within normal boundaries.
The growing case for crude oil bargain hunting at these levels can be made through the case of the developing middle class of very large Asian populations. The demographic argument states, broadly, that money follows population growth and education. Psychologically speaking, people first seek to meet their basic needs of food, shelter and clothing. As these needs are met and existence transitions to living, the population wants better food, nicer clothes, DVD players and cars. These populations will develop their economies from the inside. However, their production facilities will require more raw materials to produce an equal amount of goods than the efficient production facilities in developed countries. Their higher rate of consumption will help to support global demand for fossil fuels.
British Petroleum’s recent disaster in the Gulf will further constrict domestic supplies going forward. No one can argue the magnitude of this disaster. Many more Americans will truly see and feel the impact of this environmental calamity because it happened in the Gulf, rather than in Alaska, like the Exxon Valdez. The emotional impact will rally voters to back Obama’s moratorium on offshore drilling and put further National Park drilling in jeopardy.
Finally, let’s look at the market internals themselves. Commercial traders, via the Commitment of Traders Report have continued to buy the market the entire way down through this decline. This means that the people who live and die by this market feel that these are value prices. Their trading programs are not based on swing trading. Their trading methodologies are based on fundamental factors like supply and demand and currency exchange rates. They also incorporate seasonal usage data into their trading algorithms, which suggests the crude oil market should continue to see increased demand through the end of August.
The sum conclusion of this selloff in crude oil is that it should be viewed as a buying opportunity for the long term. This is one of the situations where efficient portfolio analysis would suggest that allocating a portion of an overall portfolio to inflation sensitive, fundamental goods would not only put your trading in line with the commercial hedgers, but also provide some overall portfolio diversification.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.
