Tuesday, April 26, 2011

Crude Oil Momentum

Crude oil momentum is commonly defined as the rate of change in the price of oil ($/bbl) of a given quality and over a given time frame. Several independent research providers that we read on a regular basis look at the 252-day (or annual) rate of change in the price of WTI (Western Texas Intermediate or Texas light sweet), which is refined mostly in the Midwest and Gulf Coast regions in the U.S. and is the underlying commodity of the New York Mercantile Exchange’s oil futures contracts. Their research indicates that, historically, excessively steep increases in the price of WTI were often followed by poor stock market performance.

Two commonly-watched critical levels for the 252-day rate of change are 33%, above which the stock market tended to trade sideways without offering significant gains, and 100%, above which the stock market tended to suffer significant slumps. The rationale behind these results is simple: given the pivotal role of oil in both U.S consumption and production, a “too much, too fast” rise in oil price may be difficult for the economy to absorb, knocking an ongoing economic recovery or expansion out of sync.

In an effort to keep a closer look on this indicator, we developed a tool that allows us to track the 252-day rate of change in the price of WTI in real time, based on daily closing prices as well as intra-day prices. What follows is our Crude Oil Momentum report, updated as of yesterday morning, when WTI spiked to $113.33/bbl.

The top chart (blue line) plots the S&P 500 and highlights a few major tops. The second chart (red line) plots the 252-day rate of change in the price of WTI and compares it to the 33% and 100% critical levels (dotted lines). From 1983 to date, the 100% critical level was reached only 5 times, which are highlighted and correspond to the major S&P 500 tops highlighted in the top chart. Grey areas in both charts correspond to official recessions, as determined by the National Bureau of Economic Research. Yesterday’s intra-day price of $113.33/bbl corresponds to a 37% 252-day rate of change, which is above the 33% critical level but still well below the 100% critical level.

Concluding the report is a table indicating how often, historically, this rate of change was within a given range, and what the average S&P 500 return was in the following 12 months. As the table reports, from 1983 to date the 252-day rate of change in the price of WTI was between 33% and 100%, as it is now, 20.6% of the time on a daily basis. Observations in this range were followed by an average 12-month S&P 500 return of -0.52%. From this point forward, it will be critical for our stock market outlook to observe whether crude oil momentum stabilizes at or below 33% or keeps climbing towards 100%.