7/30/2010
By Conley Turner, Research Analyst

More Articles by Conley Turner

Now that the first half of the year has come and gone, it is useful to consider the state of the economic recovery and by extension, the impact on oil prices.  The government recently released data showing that Gross Domestic Product (GDP) growth actually declined in the 2010 second quarter. This is important as GDP is a measures the output of all goods and services within the confines of the U.S. The Department of Commerce indicated that GDP grew by 2.5 percent during the quarter versus the official prediction of a 2.7 percent rate of growth. The reason cited for the shortfall was an overall capital investment drive by businesses. In turn, this had the effect of increasing imports at the most robust rate in more than 25 years.

On its own, the report appears to be a setback to President Barack Obama's ongoing effort to establish a sustainable recovery from the deepest recession since the great depression.  Though progress has been made as demonstrated by the previous four consecutive quarters of GDP growth, that trend does now appear to be broken. This latest economic report challenges many of the arguments put forth by market participants for any near term increase in oil demand. GDP growth typically comes with an increase in economic activity which translates into greater energy consumption. The reality in this economic recovery has been curiously different as oil inventories remain stubbornly high.  A report by the Department of Energy released earlier in the week underscores this point.  There was a build of 7.3 million barrels in U.S. crude supplies versus levels recorded in the previous week.

In a separate report however, the agency also forecasted oil to stage a sustained recovery through the end of 2010. The basis of this forecast was due to the ongoing GDP growth occurring in the rest of the world, particularly among the emerging markets countries. The Energy Department also set a yearend target of $80.74 for a barrel of the oil.

As such, it would stand to reason the recent GDP report is not a total loss for economic growth.  There are some bright spots as The Chicago Purchasing Managers Index, for example, conveyed a brighter picture on manufacturing in the Midwest. The index rose to 62.3 in July from 59.1 in the previous month.  The figure also surpassed the consensus expectation for a 56.5 decline. Furthermore, compared to where the economy is coming from, the fact that there is actual GDP growth is a reason to be optimistic that some progress is still being made albeit at a slower pace.

That said the price of crude is still at a relatively elevated level versus what is actually being consumed. This would suggest that there may be some level of dissonance between the current price and actual fundamentals.  It does not mean that a price collapse in crude oil is imminent however, as other factors are also involved in determining that outcome.  These include the impact of geopolitical events on the price, severe weather and currency movements.

At this juncture it is safe assume that there will be a significant amount of price volatility in oil for the foreseeable future.  This is predicated on the fact that oil traders and investors continue to look towards the equity market for direction and that market has been quite volatile of late. The logic being embraced is that stocks are a reliable gauge for the overall health of the economy and ultimately for energy demand. As such, in there has been a positive correlation between the performance of oil prices and the direction of equity prices in recent months.

In aggregate, despite the numerous factors that impact the price of oil on a daily basis, the secular trend does appear to be higher.  The current global economic difficulties will eventually pass and demand will return.

Conley Turner
Wall Street Strategies