An OIl Update

West Texas crude oil prices are near their best levels of the year. The front month futures contract is near $104.50 a barrel. The high, thus far, this year was set in early March near $105.20 a barrel.

Declining US inventories appear to be a factor. The EIA reported that inventories at Cushing have fallen to five year lows. This has been a trend since January as the southern tranche of the Keystone XL pipeline has been shipping oil to the Gulf refineries.

There are several geopolitical considerations and these appear to be underpinning Brent more than WTI oil. First, a break away al-Qaeda group reportedly has taken control of Mosul, Iraq's second largest city and are in a position to disrupt the country's energy infrastructure. The critical 600k km pipeline has been closed for repairs since early March. Those repairs have reportedly been disrupted.

Second, reports suggest that China's demand exceeds what is needed for immediate economic use. China is building a strategic reserve In the January-April period, China appears to have imported about 600k barrels of oil a day. Although the government data is scarce, industry watchers estimate a third to a half of the oil is for the strategic reserves.

Government figures suggest China's strategic reserves were around 141 mln barrels at the end of last year. In comparison, the US strategic reserves were just below 700 mln barrels in late May. The US strategic reserves are sufficient to cover a little more than a month of consumption (~37 days). It can hold about 95 days of imports according to industry estimates. China aims at establishing strategic reserves to cover 100 days of net imports that are something on the magnitude of 600-700 mln barrels. Its coverage of current consumption is estimated to be around three weeks currently.

Third, OPEC decided to maintain the 30 mln barrel a day ceiling for the fifth consecutive meeting this week. There was some thought that it may have chosen to boost output to offset the shortfalls of Libyan and Iranian output. In the middle of May, the IEA called on OPEC significantly increase production. Libyan output is on the magnitude of 1/10 of its pre-conflict levels. If the Iranians does not reach agreement on its nuclear program by the end of next month, the sanctions that were lifted will be re-applied.

It is not a factor driving prices, but we note that apparently under pressure from the US and the EU, Bulgaria has halted construction of a pipeline that would have carried gas from Russia that would have circumvented Ukraine. The South Stream pipeline would go under Black Seat to Austria through Bulgaria. Bulgaria is an EU member and is thought to be among the most pro-Russian member.

The EU itself has expressed opposition to the pipeline on grounds of being counter-productive to diversifying suppliers away from Russia. The US is opposed, it appears on general grounds, but also because the company being used to build the pipeline is controlled by a person who is on the sanction list. The work stoppage ostensibly took place due to an investigation into how the project's contracts were awarded.

There does not appear to be a stable correlation between the G7 currencies and oil prices. However, we do see for most of the year; the Canadian dollar (not the US dollar against the Canadian dollar) was inversely correlated with the price of oil (60-day percent change basis). However, since the start of the month the correlation has turned positive, but barely so (0.16). This correlation is just above sterling's (0.15) and is the same for Brent. Looking at a somewhat broader array of major currencies finds that the Australian dollar's correlation is also at the highest for the year, but still low (0.22). Ironically, the Norwegian krone's correlation to Brent is inverse (-0.13).