A pretty good intro…

Oil: Supply and Demand? Hardly!
By Julian Murdoch

For most commodities, you can look at the underlying forces driving supply and demand and understand what will move the market. Except, it seems lately, for oil. Prices have risen so far, so fast from their mid-February lows that some investors have started to wonder: Is the price of crude decoupling from supply and demand?

Not quite. But right now, supply and demand only tells part of the story.

Oil Supply And Demand

Globally, we are awash in oil. As reported in the EIA’s latest “This Week in Petroleum,” crude oil inventories went up yet again this week, gaining 778,000 barrels. While this increase was less than half of the 1.91-million-barrel increase analysts had forecasted, crude oil inventory is still well above the five-year average for this time of year. (Oil still dropped a bit though, due to a huge increase in gasoline inventories when the market had expected a drawdown. See “This Week’s Oil Guesses Off The Mark” for more on that story.)

OPEC has publicly stated that they believe inventories in developed OECD countries to be equal to roughly 61 days of demand—a number OPEC is none too happy about. They’d prefer the world to be constantly on the brink of running out (that is, 55 days or less). So with all of this supply, you’d expect to see OPEC talking production cuts—or at least a drop in the price of oil.

Instead, last week the group discussed the need to increase production, so as to keep oil under $80—it seems even OPEC thinks prices are still too high. As OPEC Secretary General Abdalla El-Badri told Bloomberg:

“Anything above $80 will really hamper economic growth. Watch the floating storage, if that is eliminated, and watch the stocks, if they are at 52, 54 days, then OPEC will take action.”

Of course, if the floating stocks (that is, oil stored at sea) remain at current levels and inventories stay full, then apparently OPEC will just sit back and rake in the money.

It’s The Dollar, Stupid

So if supply and demand isn’t driving oil prices, what is?

It comes back to the strength—or lack thereof—of the U.S. dollar. As OPEC member Qatari Oil Minister Abdullah bin Hamad Al-Attiyah told Bloomberg:

“Sometimes the price of oil has no correlation to demand and supply. Now what we are seeing is that oil has a strong correlation with the dollar.”

Of course, what he most likely meant to say is that right now, oil has a strong negative correlation with the dollar. Just look at the relationship between oil and the dollar since the beginning of 2007:

The top graph compares the movement of oil prices to movements in the U.S. Dollar Index, which measures the dollar against a basket of global currencies to show its relative strength (or weakness). Underneath, we’ve plotted the correlation between the dollar and oil over the same time period.

In periods of positive correlation (fairly rare for oil and the dollar), rising oil prices coincide with a strengthening dollar. But when the correlation is negative, increases in oil prices coincide with a weakening dollar—which is exactly what we’re seeing right now. As the dollar moves down, oil moves up and vice versa.

Note that although the dollar doesn’t swing very widely compared to the price of oil, the correlation between the two often does. In addition, it’s rare that oil and the dollar move in lockstep—far more commonly, the two will move in opposition to one another.

There’s an inherent logic to this: All else being equal, oil, being priced in dollars, should go up in price, simply because the dollar weakens on the world stage.

And as our friend from Qatar points out, we’re at a cyclical nadir of correlation.

Where Does Oil Go Next?

With such ample supply and prices tied more to the dollar than demand, where does the oil market go from here?

Clues can be found higher up the supply chain, since oil, like all commodities, needs to be transported. Just as looking at the Baltic Dry Index reveals insight into the health of base metals and coal markets, we can look at the tanker industry to get a feel for where the oil market might be headed.

So far, all signs there have pointed to glut as well. There is ample supply of oil tankers in most areas of the world. In fact, rental rates on ships traveling from the Middle East dipped below running costs this year, because too many ships were available, allowing oil producers to have their pick of contracts.

That may be about to change, however, as rental rates are starting to rise on routes such as the one from Saudi Arabia to Japan, which had climbed 10 percent as of October 26. As the economy recovers and oil demand begins to rise, so too should rental rates for tankers.

Nor can we forget about China, whose demand for oil continues to grow; September imports were 15 percent higher than the previous year. China has also shown an interest in acquiring more oil resources, even though many of these deals have not gone through. Last week’s “Weekly Tanker Opinion” by Poten & Partners, a global broker and commercial adviser for ocean transport, said the following:

“Though some future Chinese imports will be received through pipelines, tanker owners have reason to welcome China’s recent energy investments as they will ultimately result in incremental increases in ton-mile demand. Chinese sponsored exports have already helped transform the West Africa to Far East voyage from a sleepy backhaul into a primary money-making voyage and Venezuela’s increased exports to China have supported Caribbean to Far East rates.”

The one fly in the ointment, however, is the 890 million barrels of capacity that should come online over the next few years in the form of new tankers. More ships will add noise to any effort to use tanker rates as an early-warning indicator of Chinese demand.

Does all this mean that supply and demand no longer matter? Of course not. But it does point to the momentary hypersensitivity of oil as a dollar play, not just an energy play. With the caveat that Chinese demand seems to be staying strong, there’s little doubt the world is at least temporarily oversupplied—not at all-time highs, but replete with oil nonetheless.