Reality Bites: Why Oil Corrected

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What a year it has been for oil. After climbing almost steadily for 11 months, the start of May brought about a significant correction that pulled prices down some 15%, including a single-day $10 loss on May 5. What happened? The froth came out of the market.

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Since January, oil prices had been climbing because of events in the Middle East. Libya's war, Egypt's revolution, Syria's protests and brutal crackdowns, Bahrain's tensions - all of these fed speculation that a major disruption to supplies from the most important oil-producing region in the world might be just around the bend.

None of that has changed, really. The Libyan war still rages, Syria's president continues to kill citizens demanding freedoms, and Saudi Arabia remains held together more by money than by peace or loyalty to the royal family. What ended was the lifespan of speculation - it can only prop commodity prices up for so long before realities start to intrude. And a couple of big realities finally showed through.

The first is a massive crude oil surplus in the United States. Stockpiles rose by 1.7 million barrels in the second week of May to reach 370 million barrels. The numbers for this week were expected to push supplies to their highest levels in two years. With so much crude oil sitting in American tanks, traders could no longer pretend that potential threats to Middle Eastern supply were all important.

Second, the reality of the U.S. economy started to impact the oil scene again. New data from the Federal Reserve showed flat industrial production in April, against an expected gain of 0.4% and an increase of 0.7% in March. Industrial production is a measure of the physical output of the nation's factories, mines, and utilities. Other bearish indicators included declines in U.S. housing starts and building permits, and a 0.4% decline in manufacturing production after nine months of increases. Gold also softened and the dollar strengthened, both of which weigh negatively on oil.

Third, the Arab Spring has not yet managed to topple another regime. Syria's citizens are doing their best, but Bashar Al-Assad is the most brutal dictator in the region and appears to have no qualms about killing hundreds of Syrians and arresting tens of thousands more to maintain his grip on power. Syria itself produces little oil, but the nation plays an important regional role, aligning with Iran and the Lebanese Shiite militia Hezbollah to stand against Israeli and American aspirations. A revolution in Syria would produce a regional power vacuum that could well have negative implications for oil. However, after nine weeks of protests the Syrian people have made little progress, and so oil traders are slowly taking Syria out of the price of oil.

Combined, these factors have produced an oil price correction. The U.S. Energy Information Administration (EIA) thinks the correction will survive, and reduced its projected WTI spot prices to US$103 per barrel for 2011 and US$107 per barrel for 2012, down $4 and $6 per barrel respectively. The EIA still expects oil markets to tighten through 2012, with world demand growing and supply slowing, at least from non-OPEC countries.

The Casey Energy Team is of the same mind. Oil prices will remain pretty range-bound for the next little while, moving neither up nor down dramatically. In the longer term, though, we remain bullish on oil. In the context of the recent speculation-driven oil-price spike, we recently conducted a thorough investigation into global oil supplies, asking: where do the world's biggest economies get their oil and how stable are those relationships? We discovered that a lot of essential oil trade routes are underlaid by very shaky international relations. The conclusion that much of the oil supplied to the world's three largest economies - America, China, and Japan - is at risk only bolstered our bullish stance. It also led us to some investment ideas (think global exploration aimed at diversifying oil supply options).

[The Casey Energy Team scours all sectors of energy worldwide to find the best opportunities for solid returns, no matter which way the energy market heads. Keep abreast of developments via the Casey Energy Report - details here.]

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