Oil’s Rally: Short Squeeze Or Sustainable?

Over the last few weeks I have reiterated several times my belief that the mid $40 level would provide support for WTI crude, and so far that looks to be the case. There is nothing magical about that level; my view was based solely on the proximity to the lows seen in the depths of the recession. Even when things are going right, though, traders are programmed to look for reasons that the obvious move may not be the whole picture, and the ferocity of the bounce has me wondering…Is it just a squeeze after hitting a logical level, or is it a sustainable move back up?

Of course, without getting into the minds of the traders and fund managers who are buying there is no way to be sure, but looking at other markets can at least offer some degree of corroborating evidence to the theory that we have actually found a bottom. While the dramatic fall in crude prices was largely the result of a supply shock, there were other factors that contributed. Fear of a global slowdown and a strong dollar were also in part to blame for the drop.

It will take a while for the supply factor to self correct, but so far earnings season in the U.S. has seen a host of domestic producers indicating reduced capital expenditure and head count. If the demand outlook is somewhat better and the Dollar shows signs of a retreat from the record highs then we can be more confident that oil can stabilize, or even recover significantly, before those changes control supply enough to restore balance. There is evidence that both of those things are happening.

From a demand perspective the level of fear about prospects outside the U.S. can be determined by the performance of U.S. Treasuries. When there is doubt regarding growth elsewhere money flocks to the safety of American government paper.

The chart above (from Bloomberg.com) shows the effect of that over the last six months as yields on the U.S. 10 Year dropped to lows of around 1.6%. (For those who find the topsy-turvy world of bonds confusing, lower yields equate to higher prices.) The last week or so, however, has seen the 10 Year sold to the point where yields have returned to around 1.8%. That is not enough to indicate worry about the U.S., but it does suggest that the panic about global growth is subsiding.

Similarly, the Dollar has turned in the last couple of weeks.

In my experience, forex moves usually presage moves in other markets and that was the case here. The Dollar index started to retrace from highs two weeks ago and, despite an attempt to rally above the 95 level looks to have turned, at least for now.

Taken singularly, neither of these moves tells us anything beyond their own markets, but when viewed together with the backdrop of a jump in crude, they do suggest that some degree of confidence in global growth is returning. The biggest factor in that trend is probably the ECB’s belated acceptance of the inevitable and embrace of fully fledged QE, but the strong move up in Chinese stocks that we saw throughout December and into January probably helped too.

When we look at global markets in totality, then, the evidence would suggest that the rally in oil prices is for real. As one would expect, the Dollar led the way, but lower Treasury yields and strength in stocks elsewhere suggest that that is not an isolated move. There is no doubt that, following such an extreme move in crude, any recovery will be somewhat lumpy and there will still be some worrying volatility, but overall it looks like we may have found a bottom and the move up is sustainable.