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What fundamentals have got oil on the boil?

22 May 2009

The Macro Trader’s view:
After making lows in January and February this year, the oil market has been in a slow recovery phase. At first, the price action resembled a correction that held out the possibility the market might go on to make new lows.

But even as the leading economies were reporting their weakest growth rates to date, the oil market consolidated its modest gains. More recently, traders and analysts have turned optimistic about the possibility of recovery in the US, UK and even the Euro zone.

After Q1 GDP data in all of these economies were worse than expected, one could be forgiven for asking; where is the justification for such optimism?
In the US the Q1 GDP data was dire, but personal consumption was better than expected and held out the prospect, a view espoused by the Fed, that the recovery could begin in the 2nd half of this year if the inventory cycle put in a bottom and turned.

In the UK, despite equally weak Q1 GDP and continuing anxiety over the nations finances, the PMI services report has steadily improved over recent months, with the last reading coming in at 48.7 - a whisker away from recording growth. Moreover, retail sales have continued to hold up reasonably well.

In the Euro zone, although the pace of contraction has been worse than originally expected, especially in Germany, there are signs there too that the pace of weakening is easing, as recent industrial production data, while still weak, is contracting at a slowing pace. Additionally, the German ZEW and IFO surveys have started to show signs of improvement.

But even allowing for all of this, there is so much spare capacity in the global economy, surely demand for energy can be easily met, without any strain on supply, without driving prices back up?

While this is true, the current rally in the oil market is more to do with the market finding a new equilibrium between current economic conditions and what will likely prevail once recovery is truly under way later this year early next.

During the last period of expansion the worry was the demand/supply equation as analysts tried to get a handle on when the dreaded peak oil point will be reached; some say it is already past.

Clearly, with large countries like India, Brazil and China now established as large economies with a huge appetite for energy, the choke-off point in supply/demand could occur much sooner in the next recovery phase, and for this reason, together with the usual fears over security of supply, the oil price looks set to experience a long rally over the coming months and
probably years.

John Lewis
Seven Days Ahead

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