THE sense of crisis stalking Eurozone economies has coincided with a steep drop in the oil price. It has fallen 17 per cent in the last fortnight and the benchmark Nymex oil price is currently trading at close to $71.85 per barrel. But, even after this drop in price, some oil analysts are standing by their bullish forecasts for crude for the rest of the year.
But is this reasonable even though the world’s largest economic bloc, the European Union (EU), is currently suffering the worst crisis since it came into existence? Bank of America Merill Lynch says that although a weaker euro and weaker European economy presented some downside risk to its $92 per barrel second half 2010 forecast, “any currency impact on oil may be limited. We still believe oil prices will break through $100 per barrel some time next year”. Societe Generale does not think that the Eurozone is a particularly important driver of the oil price and calls oil “everything but a European commodity”. It expects oil to return to the $80-85 per barrel range in the coming days. In the longer-term, it expects oil to breach the $100 per barrel level by next year.
EUROPE’S EFFECT ON OIL
Such views address two obvious transmission routes from the Eurozone crisis to a change in the oil price. One is currency – a weaker euro means a stronger dollar, and the oil price often moves in an inverse direction to the dollar, so as the dollar strengthens the oil price should fall. However, this relationship is not perfect and has broken down during recent years (see chart on the right). The second way the oil price could be affected by the Eurozone crisis is through a drop in demand for oil caused by a fall in Eurozone GDP. However, although Europe’s oil consumption is by no means trivial, the Eurozone is becoming less important to global commodity markets as emerging nations such as China and India continue to drive economic growth. The result of this should be that the oil price is less affected by a contraction in European GDP in the near-term.
However, there is another way that the oil price could be dependent on how the Eurozone crisis plays out that has nothing to do with currency nor actual European oil demand. Since the start of this year the oil price has been highly correlated with movements in the equity markets, and crude is now trading like a risky asset class just as Europe’s woes wreak havoc with the markets.
OIL TRADING LIKE A RISKY ASSET
The chart on the top right bears this out. It shows three lines – the yellow one is the oil price. The red line shows a predicted oil price that is calculated using a statistical model, which combines changes in commercial positions in the oil market with changes in speculative positions in the oil market and changes in the US benchmark equity index the S&P 500.
It finds that the oil price has a high positive correlation of 0.77 with both commercial and speculative positions in the oil market and the S&P 500 equity index. This means that the model can explain 77 per cent of the movement in the oil price. It finds that the S&P 500 is by far the most important factor – for example, the effect of a one percent move in the S&P 500 has double the impact on the oil price compared to the other two demand factors. It alone explains fully 47 per cent of the oil price movement since the start of this year. The blue line on the chart shows the impact of speculative and commercial positioning on the oil price, minus the S&P 500. Since this is significantly lower than the actual oil price, you get some idea of just how crucial the equity markets are for crude.
If the oil market continues to trade like a risky asset class as it has done this year and if weakness in the European stock market infects the S&P 500, this could drag down the oil price, regardless of currency or actual physical demand issues emanating from Europe.
FOCUS | CHINESE DEMAND
Although oil has moved in-line with risky assets in recent weeks, supply and demand factors could soon enter the fray as well. There are fears that demand factors could add to the pressure on the oil price in the coming months. China’s seemingly insatiable demand for oil has been one of the key drivers of its price in recent years, but that could start to ease as authorities in Beijing increase the measures being implemented to slow down growth and prevent the Chinese economy from overheating. However, these fears are not being reflected in the market, which is currently in contango – when the current month contracts are trading at a discount to future month contracts. Currently, some futures contracts for WTI are trading at a $10 premium to June contracts.
The forward curve is telling us a different story from spot oil prices, which are coming under pressure. If demand in China starts to wane, then the oil price is likely to drop and could find it hard to recover.