Crude Oil’s Rally Not Sustainable

Crude oil prices rose sharply yesterday (Thursday), with the front-month (March) contract rising by more than 14% or $4.86 per barrel, to close at $39.48 a barrel. Prices were up for outer months as well, with the April delivery month up 7.4% or $2.77 per barrel to $40.18.

The spike resulted from a better-than-expected inventories report by the Energy Information Administration (EIA). The agency reported a modest drop in crude oil inventories as against expectations of another major build. This was the first drop in the bulging inventories since December 2008, and appeared to be an early sign that OPEC’s cuts may be having an impact.

Another positive data point in yesterday’s EIA report was favorable gasoline demand numbers. The agency reported that the 4-week average gasoline demand (for the week ending February 13) was up 0.8% from the year-earlier level. The demand number, if sustained in the coming days, will represent a major trend reversal.

It was a combination of these positives that drove oil prices higher yesterday. But is it the onset of a sustainable rally? We don’t think so, and here is why:

It will be nice to start drawing down inventories, but at current levels, they remain at very high levels.

As the above chart from the EIA shows, we would need a sustained period of drawdowns to lessen the inventory overhang plaguing the commodity. The shaded region on the chart is the 5-year range, clearly showing that current inventory levels are “off the charts.”

We remain skeptical on the demand numbers, as well. It is difficult to imagine that gasoline demand can go up in the face of continued, if not accelerating, job losses in the coming months. The sharp drop-off in gasoline prices has been helpful, but we expect that to be more than offset by economic difficulties.

Given this backdrop, we do not see yesterday’s spike as the start of a new rally, but the market’s response to a relatively positive inventory report and technical factors (the March contract is expiring next Friday).

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