HardAssetsInvestor

Written by Julian Murdoch  |

October 29, 2009

Oil: Supply & Demand? Hardly!

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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:

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.