The price of oil changed direction and tumbled during the week after it had increased during most of August and the first couple of weeks of September. What could have caused such a rapid shift in the oil market? Will this change in market sentiment bring oil prices down to their 80s? During September, the price of oil fell by 4.65%; United States Oil (NYSEMKT: USO), by 4.9%. The recent rise in U.S oil stockpiles by a higher than expected margin may have contributed to the decline in oil prices. The weaker than anticipated adverse effects of Hurricane Isaac on the production, mainly in the Gulf of Mexico, may have also helped pull down oil prices. Finally, the recent announcement of the Federal Reserve to launch QE3 may have a modest effect on oil prices. Let’s further explore these issues.
The recent tumble of oil prices has also affected several oil producers including Chesapeake Energy Corporation (NYSE: CHK) and Exxon Mobil Corporation (NYSE: XOM). During August and September, the linear correlation between Chesapeake and oil (daily percent changes) is 0.57, and between Exxon and oil it is 0.6. This means that nearly 33% of Chesapeake’s volatility and 37% of Exxon Mobil’s volatility (under the assumptions of linearly of relation and normality of data) could be explained by the changes in oil prices. The tumble of oil prices may have curbed the recent rise of these energy prices. These energy companies are also strongly correlations with the S&P500 index (during September the linear correlations reached 0.46 and 0.84, respectively). Thus, the ongoing rally of the S&P500 may have prevented, to a certain extent, these energy companies from falling. Nonetheless if the price oil will continue to decline it could affect the valuation, assuming we use DCF, of Chesapeake and Exxon. So let’s see what has changed in the oil market:
One of the main financial events of last week was the announcement of the FOMC to launch QE3 in which it will purchase mortgage backed securities at a pace of $40 billion per month. This is de facto a monetary injection that will expand the U.S. money base. This news may have contributed to the rally of oil prices last week. But will this stimulus continue to affect oil prices in the weeks to follow? As presented in the chart below, despite the sharp rise in the U.S money base during 2009 and 2011 it didn’t seem to have a strong effect on the price of oil that was more affected by the changes in supply and demand, most notably the turmoil in the Middle East that pulled up the price of oil during 2011.
Further, the linear correlation between the two shifted through the years: between the years 2000 and 2008 the linear correlation was negative at -0.51, which means that as the money base expand the price of oil tended to fall. Since there weren’t sharp rises in the U.S money base, this correlation didn’t place much concerns for oil traders. On the other hand ever since the Fed started to inject the U.S economy with money pumps by implanting QE1 and QE2 the correlation between oil and U.S money base became positive: between the years 2009 and 2012 the linear correlation between the two reached 0.1. This weak correlation, however suggests that if there is an effect of the changes in the U.S money base on oil prices, it is weak and doesn’t play a strong role in the factors affecting oil prices. This weak relation could also suggest that the QE1 and QE2 didn’t have a strong effect on the U.S economy and thus didn’t affect much its demand for oil.
Thus, even after the launch of QE3 by the Fed, I suspect it may have little effect on the price of oil and the true factor will continue to be the changes in demand and supply and projections about them.
Let’s examine the changes in the fundamentals including the U.S oil storage and production.
From the Supply side the U.S oil production rose by 0.1% (week over week) and was also 6.7% above the production level in 2011. Imports also rose by 4.8% (W-o-W). This mean the U.S supply slightly expanded. Alternatively, during last week, refinery inputs decreased by 0.9%. The recent shut down of oil refineries during the end of August at the Gulf of Mexico due to Hurricane Isaac didn’t seem to have much of an adverse effect on production. Nonetheless, we are still in Hurricane Season so there is still uncertainty around the adverse effects Hurricanes or tropical storms could have on production.
Last week, the U.S. Petroleum and oil stockpiles rose by 11.4 million barrels; it reached 1,801.5 million barrels. This injection was much higher than many had projected. The current oil stockpiles are 27.5 million barrels above the levels were during the parallel week a year back. The linear correlation between the changes in stockpiles and oil prices is mid-strong and negative, which mean that if oil stockpiles will further increase, it could suggest that oil prices are likely to keep falling.
The recent developments in U.S oil market including the rise in production and storage may have contributed to the tumble of oil prices. These changes are likely to contain oil prices from rising precipitately, as they did during August and the first two weeks of September, in the near future. Nonetheless, the recent stimulus of the Fed and ongoing uncertainty around the production due to weather changes, and the tension in the Middle East are likely to keep oil prices high compared to recent years. So I guess the prices of oil will remain in the low 90s in the near future.
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