I have been consistently bullish on crude oil prices since the spring of 2009. Most recently, at the beginning of 2011 I called for a spike to above $120/bbl at some point during the year. My prediction came true far earlier than I had anticipated due to the interruption of Libya’s 1.5 million barrels per day in crude oil exports.

My April call for a pullback was not a long-term outlook and implies no change to my longer-term constructive view on oil prices and related stocks. Rather, it was simply recognition that oil prices had run up too far too fast and were due for some sort of consolidation and profit-taking. That correction is now underway–check out my chart “Net Oil Longs” for a closer look.

Source: Bloomberg

This chart shows the net long position of non-commercial traders in the NYMEX WTI oil futures market as a percent of total open interest. When this line rises, it means that crude oil speculators are aggressively buying oil futures.

As you can see, this measure was overwhelmingly net long in mid to late April. Since then, as crude oil futures have declined from their highs, so has the net long position of futures traders. A further look inside the data shows that the cause of this decline is that oil traders are selling off their long oil futures contracts; while the number of shorts has increased somewhat, bets against oil don’t really factor into my chart.

This is consistent with the view espoused here one month ago, namely that crude oil prices were due for a correction as institutional traders take profits on their long positions after a major run-up. They’re not betting against oil.

A tight supply and demand environment for crude is the main driver of prices, not speculation; traders in the oil market are simply taking positions in reaction to these fundamentals. Any long-term divergence between oil prices and fundamentals would cause physical dislocations in global oil markets. Nevertheless, speculators clearly can move oil in the short run and are prone to the same animal spirits that drive all traders–bouts of over-exuberance and extremes of bullish sentiment such as we witnessed this spring are eventually corrected.

There are always near-term catalysts for profit-taking. I have heard dozens of explanations for the most recent bout of selling, but the two most logical justifications are a rise in the value of the US dollar and another economic growth scare.

The Dollar and Oil

It seems that whenever pundits can determine no other reason for rising or falling commodity prices, they roll out the old tried-and-true weak-dollar argument. The connection between the value of the dollar and commodities is overplayed and acts as a crutch for those desperate for an easy-to-understand rationale to explain away price movements.

There is some truth to the connection between the dollar and oil, at least on a short-term basis. After all, oil, like most other commodities, is priced in US dollars, so when the value of the dollar declines against the euro and other major currencies, it stands to reason that its value against a basket of hard assets would also decline.

The problem arises when people begin to believe that the falling dollar is the sole driver of commodities prices over a longer time frame, a simplistic and naïve assertion. Consider that from late November of 2009 through the spring of 2010, the US dollar index–a measure of the value of the dollar against a basket of major currencies–rallied steadily while oil followed suit by rising from late 2009 through the end of April.

Furthermore, in early June of 2010, the US dollar index stood at around 88, almost exactly the same level as in early March of 2009. Over this time period, crude oil prices nearly doubled from the low $40s per barrel to the low to mid $70s per barrel.

Of course, oil’s historic run-up from 1998 through 2008 coincided with a period when the dollar was generally weak. The dollar index fell from about 98 in early 1999 to around 72 in the middle of 2008, even as oil prices soared from $10/bbl to nearly $150/bbl. But that’s not to say the dollar drove crude: Oil prices in euro terms climbed from just over EUR10 per barrel in 1999 to EUR90 per barrel at their highs in 2008. You can’t explain away a near ten-fold increase in oil prices with a 25 percent decline in the US dollar index.

Nonetheless, commodity traders do often take their cues from the dollar in the short-run. In particular, a sudden acceleration in the trend of the dollar’s price compared to other currencies can cause spikes or sharp corrections in oil prices. Check out my chart “The US Dollar Index” for a closer look.

Source: Bloomberg

This chart shows the long-term trend in the US dollar index. Note that the spike in the value of the dollar and the sharp sell-off in the euro in recent sessions occurred amid near multi-year lows. Just as sentiment on oil got too bullish in April, sentiment on the dollar got too bearish a few weeks ago.

On the fundamental front, comments out of the European Central Bank (ECB) suggest that Europe may be slower to raise rates than many market watchers expected earlier this year. The recent dip in oil and other commodity prices may actually give central bankers additional cover to keep rates ultra-low for longer–inflation driven by commodity prices has been the primary concern behind rate hikes this year.

At the same time, the end of the Federal Reserve’s second round of quantitative easing in June means that US monetary policy isn’t likely to get any more accommodative than it already is. Rising rates in Europe relative to the US has been a major driver of the weak dollar, but that trend appears to be reversing course.

That being said, this latest move represents a bounce in the dollar within a long-term downtrend. The severity of the euro’s decline spooked some investors out of commodities, and I can see more upside for the dollar and more downside for crude in the short term; crude still hasn’t attained the downside targets I outlined at the beginning of this report.

But I don’t see this as a long-term headwind for crude. Oil has rallied before in the context of a gradual rise in the dollar and I doubt this represents a major change in currency market trends.

The Soft Patch

The more serious headwind for crude oil at present is the potential for a global economic slowdown. A year ago, a clear weakening in economic data and a mini credit crunch in Europe prompted some pundits to call for a “double-dip” recession. This growth scare led to a severe 27 percent pullback in crude oil prices as well as the worst correction for the stock market since the end of the 2007-09 bear market.

I regard a growth scare as a far bigger risk to oil prices than a simple pullback from overbought levels, some spillover from a stronger dollar or any moves by regulators or exchanges to curb “speculation.” These exogenous factors can have only a short-term impact and don’t affect the supply and demand for oil. Global growth is always THE key fundamental to watch.

Economic data often moves in mini-trends. For example, early last summer the US experienced a soft patch followed by a notable re-acceleration in growth from late summer through early 2011. Over the past few weeks, data from the US and some other nations has shown signs of moderating. Over this entire period, the US economy has been growing. But the rate of growth has a tendency to meander around a basic trend; this is nothing unusual, every expansion sees periods of improving growth and periodic growth scares.

I am most concerned about two key fundamentals: the recent pick-up in US initial jobless claims and the April Non-Manufacturing Purchasing Manager’s Index (PMI).

I highlighted the former concern in the May 13, 2011, issue of PF Weekly “The Truth About Jobs.” Initial jobless claims measure how many workers are filing for first-time unemployment benefits in the US; the four-week moving average of claims is one of the best leading indicators of trends in the labor market you’ll encounter. As I explain in the May 13 issue, initial claims have jumped of late, leading some to question the sustainability of the recent string of better-than-expected monthly employment reports.

A good deal of the recent up-tick in claims can be explained by certain special factors highlighted by the Bureau of Labor Statistics. For the most part, these “special factors” are the product of one-off factors that have skewed the government’s seasonal adjustments to the data. But there is an open question as to whether these factors can explain all of the deterioration–I’m not fully convinced that’s the case.

The Non-Manufacturing PMI is even more troubling because I can see no reasonable explanation for its recent severe deterioration other than some actual softness in the service sector of the economy–check out my chart “Manufacturing PMI Vs. Non-Manufacturing PMI” for a closer look.

Manufacturing PMI Vs. Non-Manufacturing PMI

Source: Bloomberg

This chart shows the Manufacturing and Non-Manufacturing Purchasing Manager’s Indexes. This is among my favorite leading indicators of health of the US economy–levels above 50 are generally indicative of growth while levels under 50 suggest contraction. Looking at the actual long-term history of this data, the general rule of thumb is that a decline to below 46 or 47 indicates that the economy is headed for recession.

As you can see, the Manufacturing version of PMI remains strong and is hovering above 60. That reading is consistent with overall economic growth closer to 4 percent and certainly far superior to the 1.8 percent pace logged in the first quarter.

The Non-Manufacturing PMI pulled back sharply in April, back to levels last seen in the summer of 2010. The Non-Manufacturing PMI data can be volatile and current levels are still consistent with growth. But the severity of the decline is worth watching closely.

The deterioration in Non-Manufacturing PMI may well be a response to the spike in oil prices in the early part of 2011 because these data series are based on sentiment and survey data. If that’s the case, I’d expect the recent pullback in crude to partially reverse the April decline over the next month or two.

But there are two important points to take away from this economic data.  First, none of it is consistent with a recession or outright contraction in the economy. Last summer I was adamant that there would be no double-dip recession and that the bears were jumping the gun based on prevailing sentiment rather than a hard look at the data. Anyone who looks at current trends and predicts a recession this summer is making exactly the same mistake.

In fact, I would argue that the severity of the slowdown in the data so far this spring is less pronounced than was the case one year ago. Unless there is a further meaningful deterioration, I would look for a smaller correction in oil prices than we experienced last summer.

Also note that despite the recent headlines about Greece, the European “crisis” looks far more in hand than it was a year ago. In particular, credit default swaps for Italy and Spain–the biggest of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain)–have generally fallen this year, a sign of growing confidence that neither Italy nor Spain will see the level of severe fiscal strain that Greece, Portugal and Ireland have experienced.

In addition, there are some emerging upside catalysts for global markets as well. First, an easing in commodity prices from ultra-high levels is beginning to filter through into inflation data. For example, Chinese food price inflation is down notably from where it stood earlier this year, and the ECB has moderated its hawkish talk as commodity prices have softened. Tightening monetary policy, particularly in the emerging markets, has been a headwind for both stocks and commodities this year. With the emerging-market inflation story past its peak, look for a return of interest in these markets.

Analyzing markets, economies and sentiment is never an exact science and there is some legitimate uncertainty out there. But, the balance of the evidence continues to suggest that recent volatility in oil prices is simply the correction and buying opportunity we’ve been waiting for, not the beginning of a bear market.