Commodities | Jul 13 2011
By Michael Boutros, Currency Analyst
Our analysis forecasts Crude Oil prices to fall in the second half of 2011, with the benchmark West Texas Intermediate to challenge $80 per barrel. This decline is based on a number of factors, including the ending of stimulus programs by central banks and lower economic growth expectations across the globe. That having been said, we have considered the currently known and expected factors that affect oil prices, and our analysis points to a price decline in the second half of this year.
Central Banks Scale Back Stimulus Measures – The End of QE2
At the peak of the recession, falling asset prices and a lack of access to funds saw businesses struggle to stay afloat. In response, central banks around the world embarked on a mission to stimulate their respective economies through low interest rates and quantitative easing measures. These measures helped support access to cash amid massive global deleveraging by adding huge amounts of liquidity to the financial system. Now that markets seem to have regained their footing, central banks face the monumental task of removing these easing policies while continuing to keep liquidity flowing to businesses and private investors. In short, borrowing costs are likely to slowly rise. Asset markets may react negatively, as it becomes gradually more expensive for speculators to borrow in order to invest. Subsequently, energy costs are likely to come under pressure, with crude at the forefront of these declines.
Growth in the United States Continues to Disappoint
The Federal Reserve recently revised down its economic outlook for 2012. The Fed now expects the US economy to expand by 2.7% to 2.9%, which is down from April’s forecast of 3.1% to 3.3%. When considering the withdrawal of the extraordinary measures that the Fed had put in place at the height of the recession, it is easy to fathom a decline in economic growth as markets suffer withdrawal symptoms and liquidity tightens. With unemployment remaining “frustratingly high,” a depressed housing market, and sluggish wage growth still plaguing the US economy, demand for oil is expected to ease. And with the recent string of softer than expected economic data prints from the world’s largest economies, including China, concerns about a global slowdown have begun to take root.
China’s Attempt to Spur Economic Growth through Lending May Backfire
Concerns that the Chinese central bank will take more steps to curb inflation have continued to mount after the Fed cut its economic growth forecast in June. The People’s Bank of China (PBoC) has raised reserves 12 times and hiked interest rates 4 times since the start of 2010 in an attempt to cool China’s overheating economy. The nation’s largest banks now face reserve ratios of over 20%, and that could rise further. The subsequent crunch in short-term liquidity is evident in China’s repo rate, which is viewed as the most important gauge of short-term funding. This rate has recently risen to three year highs.
China is the world’s single largest energy consumer, and Chinese government’s attempts to apply the economic brakes are likely to send oil prices on the defensive. The data continues to suggest that the Chinese government’s recent efforts to tighten monetary conditions in the wake of the recession have placed a great deal of stress on businesses who now face elevated borrowing costs. If China’s war on inflation continues on its current track, growth prospects in the world’s second largest economy are likely to fall, and so is demand for oil.
Governments Step In to Support Oil Supply
In June, the International Energy Agency (IEA) announced that it had authorized the release of 60 million barrels of oil from the Strategic Petroleum Reserve in order to help bring down crude prices and offset supply shortages that had been caused by the ongoing conflict in Libya. The move was prompted after OPEC failed to boost production at its June 6th meeting, and comes despite pledges by Saudi Arabia, the world largest producer of oil, to raise production if needed. With the IEA and US government pledging to keep reserves on tap and the White House reiterating that this may not be a “one time thing,” oil supply should remain relatively stable despite the 140B barrels lost as a result of the Libyan conflict. That dwarfs the 38M barrel disruption caused by Hurricane Katrina in 2005. Katrina was the last time the SPR was tapped, with 21M barrels being released. With the SPR well stocked with an inventory of 690M barrels – well above the 20yr average of 500M – crude prices should continue to ease.
Classic Correlations Call for Weakness
So called “commodity currencies”, such as the Canadian dollar (CAD), tend to be a good gauge of sentiment and risk appetite across markets. Canada ranks among the top 10 oil exporting nations, so the CAD is highly correlated to fluctuations in crude prices. As the chart above illustrates, the Canadian dollar’s correlation has remained above 0.85 since early April as fears that the global recovery may be faltering saw commodity prices ease, along with the CAD. With Canada’s largest trading partner, the United States, now projected to see further weakness in its economy, prospects for the CAD seem weighted to the downside.
Using the Canadian dollar as a gauge of risk appetite, the CAD is projected to continue to ease heading in to the second half of 2011 as safe haven flows see investors jettison higher yielding, growth linked assets for the safety of the greenback. Subsequently, a decline in crude prices is likely to accompany a decline in the currency as global demand for oil wanes.
Risks to Our Bias
With all the factors taken into account, it must be noted that risks of crude spikes depend heavily on the geopolitical backdrop in the Middle East and North Africa (MENA) region. Although news of nationwide revolts and revolutions may have been on the backburner in recent weeks, the possibility still remains for tensions to suddenly flare up in the world’s most volatile region. It was only a few months ago that crude oil looked to be heading for $120 per barrel on concerns that revolts in Tunisia, Egypt, Bahrain, Yemen, and Libya threatened stability among their oil producing neighbors, as well as transport links through the region. Since then, tensions have eased somewhat, though conflict continues in Libya, and could erupt at any time in Syria, Jordan, Bahrain, Iran, Algeria, and elsewhere. Should an uprising once again take center stage, the resultant fears of supply shocks could easily cause crude prices to see another test of the May highs above $114 per barrel.
Important Levels to Watch
In recent years, we have seen crude prices surge more than 240% for an annualized gain of 74%. The rapid appreciation was due in part to stimulus measures implemented by central banks in an attempt to support economic recovery after the largest global recession in recent history. Commodity prices surged as record low borrowing costs saw investors flocking into growth-backed assets, such as oil and other commodities. Coupled with the unrest seen in the MENA region, crude continued to see higher highs until peaking just shy of $115 per barrel in the spring of 2010. As central banks now adjust policy initiatives to target rising food and energy prices, commodities should continue to come under pressure. Accordingly, risks to crude prices remain to the downside after breaking below $96.27. This level is the 23.6% long-term Fibonacci retracement taken from the December 2008 ascent. Interim support is seen at the $92 mark, with subsequent price floors eyed at the 38.2% Fibonacci retracement just below the $85 level and the 50% retracement at $75.50. A break below $75.50 risks further losses for oil, with stronger support seen at $66.25, which is the 61.8% Fibonacci retracement.
The views expressed are not FNArena’s (see our disclaimer).
For real time news and analysis, please visit http://www.dailyfx.com/real_time_news
DailyFX provides forex news on the economic reports and political events that influence the currency market. Learn currency trading with a free practice account and charts from FXCM.
www.dailyfx.com
Disclaimer
Forex Capital Markets is headquartered at Financial Square 32 Old Slip, 10th Floor, New York, NY 10005 USA.
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before you decide to trade the foreign exchange products offered by Forex Capital Markets, LLC, Forex Capital Markets Limited, inclusive of all EU branches, FXCM Asia Limited, or FXCM Australia Limited, any affiliates of aforementioned firms, or other firms under the FXCM group of companies [collectively “FXCM Group”] you should carefully consider your objectives, financial situation, needs and level of experience. If you decide to trade foreign exchange products offered by FXCM Australia Limited you must read and understand the Financial Services Guide and the Product Disclosure Statement. FXCM Group may provide general market information and commentary which is not intended to be investment advice and the content of this email must not be construed as personal advice. By trading, you could sustain a total loss of your deposited funds and therefore, you should not speculate with capital that you cannot afford to lose. You should be aware of all the risks associated with trading in foreign exchange products. Foreign exchange products are only suitable for those customers who fully understand the market risk. FXCM recommends you seek advice from a separate financial advisor.
FXCM Group assumes no liability for errors, inaccuracies or omissions in these materials and does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. FXCM Group shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. This email is not a solicitation to buy or sell currency. All information contained in this e-mail is strictly confidential and is only intended for use by the recipient. All e-mail sent to or from this address will be received by the FXCM corporate e-mail system and is subject to archival and review by someone other than the recipient.”
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.