Another False Rally in Oil

Most people who study energy markets believe that, at some point, oil will recover, at least partially. Not even the most bullish observers see $110/Barrel oil returning in the foreseeable future but a bounce back to around $50 is a common prediction. Those predictions got a lot of airing this week as oil bounced off of the recent lows in the mid-$20s, but a look at the reasons for that bounce and the fundamental situation suggests that this may be just another false dawn, and at least one more test of the lows will be needed before there can be a meaningful, sustainable recovery in oil.

The main thing that sparked the rise was the revelation at the end of last week by the UAE Oil Minister that some OPEC countries were talking about the supply situation. As it became known that Russia and, more importantly, Saudi Arabia were involved it looked like something of real significance. There has been so much talk of the complete collapse of OPEC that any hint of agreement was seen as a positive for the commodity.

That sentiment was so strong that, even when the limited and somewhat disappointing details of the proposed agreement were released this week the rally continued. The fact that even the Iranians agreed to the proposed production freeze at current levels added fuel to the fire. In reality, though, a freeze at current levels does nothing to alleviate the pressure on oil. We are at record high production levels, and it will take some time for global demand, which is increasing but at a slow rate, to even catch up let alone to make a dent in the significant stockpiles of oil that currently exist.

That didn't seem to matter, though; a market starved of good news seized on any compromise as a positive and WTI jumped close to twenty percent over a three day period. Market dynamics no doubt played a part in that exaggerated move; once an excuse was found for a move up some sort of short squeeze was inevitable and the sudden run up had the feeling of just that.

Later this week, however, reality intruded when U.S. crude inventory numbers showed an unexpected build, despite increased refinery activity. The simple fact is that the oil industry is currently producing more oil than the world needs, and freezing at these levels, while a start, doesn't address that basic problem. If that were the only thing affecting the oil price, however, the short squeeze may have been enough to at least allow the price to stabilize above the previous lows, but it isn't.

The biggest fundamental factor on the price of anything is the relative strength of whatever it is priced in. In the case of oil, that is the U.S. Dollar, and if dollars are perceived as generally more valuable, then anything priced in dollars loses value. What gave real strength to the rally last week was that it coincided with a mini collapse in the dollar index, down from highs around 100 to around 95. That move is now showing signs of reversing, though, and if that continues the upside for oil is extremely limited.

(Click to enlarge)

Figure 1: Dollar Index 6 Month Chart

In short, then, as welcome as this week's "recovery" in oil prices was to many, it looks doomed to be short lived. Until the fundamental factors affecting the price of oil, over supply and a strong dollar, actually change, any rally is a trading opportunity, but not a real recovery. Given that, another test of the lows looks to be on the cards over the next couple of weeks. Maybe, if that comes, it will be enough to force meaningful production cuts in the U.S. and OPEC countries and/or those lows could coincide with a delayed rate hike by the Fed, in which case the scene would be set for a real bounce. Absent that, though, this looks like just another false rally.