Oil's Strength Reflects Turnaround Expectations - Market Analysis
While oil's recent move above $80 a barrel is a result of the extremely frigid weather in the U.S. and Europe, it nevertheless brings into sharp focus the commodity's changing fortunes.
As we discuss in this week's Roundtable Review: Early Views on the 2010 Market, oil's recent strength reflects growing optimism about the commodity's long-term outlook. After all, if the market was evaluating current supply-demand fundamentals only, the commodity would not have made the extent of gains it has made already.
Oil Rallies Despite Weak Fundamentals
Oil demand has been hit hard by the global downturn, a trend that is only now reversing, albeit at a very slow pace. Supplies, on the other hand, did not adjust to the recession-hit demand, resulting in almost overflowing storage tanks. At Cushing, Oklahoma, the delivery point for the NYMEX crude oil futures contract, crude oil storage levels remain at multi-year highs; highlighting the commodity's unfavorable fundamentals.
The chart below from the Energy Information Administration (EIA) about the current commercial oil stocks for the OECD markets (essentially the entire developed world) is representative of the oversupplied markets. The shaded portion represents the historical range.
Because Outlook for the Global Economy Has Improved
Oil's phenomenal rise to almost $150 a barrel in mid 2008 was driven by galloping demand from new consumption centers, particularly in emerging markets such as China and India/ In fact, approximately two-thirds of the demand growth in the five years prior to the onset of the global economic downturn came mostly from China and other faster growing emerging markets. The U.S., the largest global oil market, accounted for most of the other one third growth in demand, while demand in Europe and Japan was essentially flat.
Oil's ability to rally from its low of near $30 a barrel early in 2009 is due primarily to an improving long-term outlook. It is not just the U.S. economy that has started growing again, but the outlook for the entire global economy has improved. Super-charged growth rates in China and India appear to have come back following very brief hiccups.
This is expected to reverse the negative demand trend of the last two years, as depicted in the chart below from the EIA. Please note that the global demand growth comes mostly, if not entirely, from emerging markets.
Oil - A Play on the Global Economy
But the supply of and demand for oil are hardly the only forces at play in the oil market. Way too many variables are at play here, from exchange rates and disasters (natural and otherwise) to politics and geostrategic tensions.
While many of these variables are difficult to handicap at this point in time, it is fair to state that in the current environment crude oil has become a play on the economic turnaround. As such, we look for increased oil price momentum in the coming months as the favorable outlook for the global economy takes hold.
But Rising Prices at the Pump Also Weigh on Retail Recovery
But how does rising oil price affect overall consumer demand, particularly a consumer that is already quite weak?
It is clearly an understatement that the U.S. consumer has been hit hard in this downturn. With massive job losses and continued access-to-credit issues, it will be a while before we get anywhere close to pre-downturn retail consumption levels in the U.S. economy. We have seen some signs of life in recent monthly retail sales numbers and the holiday shopping season was not as abysmal as initially feared.
The retail recovery, while clearly underway at present, remains fragile and far from self sustaining. Rising prices at the pump work as an additional tax and are not helpful to the recovery. Historically, consumers start taking notice as prices at the pump go above the $3 a gallon level (for regular/unleaded gasoline). Gasoline prices steadily inched up last year, reaching the current level of around $2.60 a gallon. While we remain below the 2008 high of above $4 a gallon, we are not that far from the all-important $3 a gallon level.
Portfolio Changes
We made just one change to the Focus list portfolio, while the Growth & Income portfolio remain unchanged. The Timely Buys portfolio also had a number of additions/deletions this week.
We deleted MDU Resources (MDU) from the Focus List. This electric/natural gas utility and E&P player fell to a Zacks # 4 Rank (Sell); prompting the deletion.
Our outlook for the commodities group remains favorable and we will be looking to diversify into this area going forward.
