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Tuesday, December 28, 2010

Why Are Crude Oil and Gasoline Going Up ?

It's not because of dwindling inventories or burgeoning demand, explains Dian Chiu, in her article, 'Outlook 2011 for Crude Oil and Gasoline: Escalator Up and Elevator Down'.  

First, refineries recently drew down crude inventories not to meet demand, but as part of their "year-end strategy to minimize potential taxes on year-end inventory."

Second, there are ample supplies of oil, with OPEC spare capacity double the level of 2007, and world oil inventories " at 20 days worth of demand, up from 14 days in November 2007 ".

Third, two previous times when gasoline cost $3 or more per gallon, in 2007 and 2008 respectively, not only was U.S. unemployment rate at 4.6% and 5.8% respectively, but "there was actually a global supply crunch due to robust (pre-crisis) global growth."

So with demand depressed due to the global slowdown, why are oil and gasoline heading higher ?

Chiu explains that QE2 - the Fed’s second round of Quantitative Easing--has stoked inflation concerns, which, among other things, "have driven investors to plow money into the commodities and stocks at a record pace."

The result ? Equity and commodity markets are currently artificially bootsed by QE2 and therefore "largely detached from the market demand and supply factors, where traders / speculators will run the show, at least through 2011."

Chiu foresees more downside than upside for oil in the near term, based on a number of factors, including

    * Slowing growth in China and India, both of which have enacted measures to fight inflation and which " would crimp growth as well as oil demand in both countries, the major growth engine of the world. "
    * Skyrocketing oil prices, which " could trigger a global recessionary cycle "
    * Worsening of the European debt crisis
But Chiu admits that if the global economy picks up steam, that, combined with inflation worries and QE2 could drive crude to $110 to $115 a barrel --and gasoline at between $3.70 and $3.80 a gallon--by the late 1st early second quarter of 2011.
Right now, speculative longs are dominating the crude market with hedge-funds and other large speculators. Long positions outnumbered short positions by 205,890 contracts in the week to Dec. 14, according to the Commodity Futures Trading Commission (CFTC).
Whenever you have an over-bullish market like this, it sets up for increasing risk and huge swings, particularly for crude oil, as it is one of the most widely traded and speculated asset classes in the world. Liquidity could only drive prices up to a point as there is no real strong demand to support the lofty $100+ crude price levels, but plenty of land mines to spook an exit en masse.
So, expect volatility to be the major theme in the New Year with crude oil taking the escalator up, but the elevator down, and a couple of $12-$15 moves in both directions along the way.