West Texas Intermediate (WTI) crude oil prices tumbled 30 percent from their high of $110 per barrel in late February to less than $80 per barrel toward the end of June. Meanwhile, Brent crude oil declined from a 2012 high of more than $128 per barrel to a recent low of less than $90 per barrel.

The drop in oil prices far exceeds the decline in equities: At its June low, the S&P 500 had given up almost 12 percent from its 2012 high.

In recent weeks, we’ve received a number of emails from subscribers asking about our outlook for oil prices and what the decline in energy prices means for our Portfolio holdings.

First, let’s look at what’s driving the recent weakness in oil prices. Investors have grown increasingly concerned that the slowing global economy will erode demand for crude oil. Although EU oil consumption will weaken and China’s economic growth has slowed relative to prior years, the recent drop in oil prices already more than reflects these headwinds. Moreover, current prices don’t reflect the potential for emerging-market oil consumption to pick up in the second half of the year. Investors also shouldn’t discount the stimulative effect that lower oil prices will have on the US economy and demand. 

Source: Energy Information Administration

In the first 25 weeks of 2012, US crude and refined products demand has declined by 3.18 percent from year-ago levels. Some of this weakness reflects reduced demand for heating oil during the unseasonably warm 2011-2012 winter. However, other factors are at work: Through the end of April, US gasoline consumption had slipped 1.4 percent year over year, while jet fuel demand was down 0.8 percent.

The four-week moving average of US oil and refined-products demand shows a clear break in the steady uptrend in US oil consumption after the Great Recession. As the economy recovered and the credit crisis eased, US oil demand bounced off its 2009 and early 2010 lows but never regained its pre-2007 levels. In fact, the nation consumed less oil in 2011 than a decade earlier.

Although the US remains the world’s largest oil consumer in absolute terms, the decline in domestic consumption is neither an unforeseen development nor a major driver of oil prices. The International Energy Agency’s February Oil Market Report forecast that North American oil demand would decline by 109,000 barrels per day in 2012; the agency subsequently revised this estimate to 194,000 barrels of oil per day–still an insignificant volume in a global market that amounts to 90 million barrels of oil per day.

This year, rising oil prices have contributed to demand destruction in the US. US retail gasoline prices peaked in early April at almost $4 per gallon and have declined steadily since; in fact, retail gasoline prices have dropped for 11 consecutive weeks–their longest continued downtrend since the dark days of 2008.

But demand has rebounded as oil prices have declined. In April, US gasoline consumption was down only 1 percent from year-ago levels, while weekly data from May indicates that gasoline demand was up 0.15 percent compared to the same month in 2011. Falling retail gasoline prices at the beginning of the summer driving season should support an uptick in US oil consumption.

Similarly, elevated oil prices have been a major headwind for the US economy. Check out this graph comparing monthly changes in the US Consumer Price Index (CPI) to noncore CPI, a measure of inflation that excludes food and energy prices. As you can see, CPI ran well ahead of the core number early in both 2011 and 2012

Source: Bloomberg

Last year, the spike in CPI reflected an upsurge in food and energy commodities, driven in part by rising crude oil prices after the outbreak of civil war in Libya and speculation that the Arab Spring uprisings would spread to Saudi Arabia.

This year, energy prices spiked because of escalating tensions between the West and Iran, as well as significant project delays in non-OPEC countries outside North America. When CPI rises at a faster pace than core CPI, US consumers must spend more on energy and less on other items.

US retail sales data weakened in the wake of the 2011 oil price spike and appear to be weakening in response to the 2012 run-up in oil prices. But with core CPI beginning to fall in May 2012, this headwind is becoming a tailwind. In summer 2011, lower oil prices helped to support retail sales; we expect this year’s prolonged decline in energy prices to have at least an equivalent impact.

As you might expect, historical data tracking the miles driven by vehicles in the US exhibit similar trends to US oil and refined-product consumption over the long run.

Source: US Dept of Transportation

The 2007-09 financial crisis and the lackluster economic recovery have ended a long-running uptrend in miles driven.

But the pace of the decline in miles driven has slowed. In the first three months of 2012, Americans drove about 1.4 percent more miles than they did in the first quarter of 2011, despite higher year-over-year gasoline prices. The unusually warm 2011-12 winter and the lack of significant snowfall likely contributed to this trend. However, vehicle miles driven in the Gulf Coast and the Southeast–states less impacted by winter weather–were up 1.0 and 0.8 percent, respectively, in March, the latest month for which the government has supplied data.

Americans also may have reached their limit in terms of cutting back on their car travel. Although sky-high gasoline prices and weak economic growth may have reduced the appeal of long road trips, it’s much harder for consumers to cut back on commutes to work or short trips near their home.

The only other way to cut back on fuel consumption is to buy a more fuel efficient car. But fuel economy takes a long time to have a meaningful impact. The average age of US passenger cars reached a record high of 11 years in recent months and has risen steadily from about 8.5 years in the mid-1990s.

Almost 250 million cars are on the road in the US; even if new car sales return to pre-crisis levels, it would take time to renew and upgrade the US automobile fleet.

Given the stabilization of vehicle miles driven, the lack of a near-term bump in fuel efficiency and falling energy prices, we expect US oil demand to decline only slightly in the near term.

Meanwhile, the EU faces severe economic headwinds related to the Continent’s ongoing sovereign-debt crisis and painful budgetary cuts. Economic conditions in Europe have deteriorated to the point that a mild-to-moderate recession is a virtual certainty.

Check out this graph tracking the purchasing managers index (PMI) for the EU manufacturing sector. Readings greater than 50 indicate an expansion in economic activity; PMI values of less than 50 indicate a contraction, with data points below 45 or 47 indicating that a recession is imminent or in force.

Source: Bloomberg

The June PMI reading of 45.1 is tied for the worst reading in three years. Italy’s PMI clocked in at 44.6 in last month, while France posted a reading of 45.2 and Germany’s PMI barely managed to hold above 50.

Peripheral EU economies such as Greece, Italy and Spain remain the epicenters of the sovereign-debt crisis.

A year ago, yields on bonds issued by Italy and Spain’s governments surged to unsustainable levels. The European Central Bank (ECB) provided some momentary relief by agreeing to purchase bonds on the secondary market in August 2011. Four months later, the ECB implemented long-term refinancing operations (LTRO) that enabled European banks to borrow money from the ECB over three-year periods at preferential rates. This eliminated some of the immediate liquidity concerns surrounding EU banks.  

Source: Bloomberg

But by March 2012, yields on Italian and Spanish government debt climbed once again. On June 28, the EU announced additional measures to address the credit crisis.

A new banking regulator will be established under the auspices of the ECB. Once this new regulator is in place, the European Stability Mechanism (ESM)–the region’s EUR800 billion ($1 trillion) permanent bailout fund–will be able to recapitalize banks directly. Prior to this agreement, the ESM and its predecessor, the European Financial Stability Fund (EFSF), could only lend to national governments that, in turn, would lend to financial institutions. 

This move will keep the EUR100 billion that Spain received to bail out its banks off the government’s balance sheet. The cost of recapitalizing Spain’s banks would have further bloated the nation’s ratio of government debt to gross domestic product (GDP), limiting the country’s ability to borrow money.

Spanish government bonds purchased as part of the bailout and loans made to support Spain won’t take seniority in the event of a default, a move that should attract private investors to the market. By encouraging private investors to purchase bonds issued by the Spain’s government, policymakers hope to avoid future bailouts.

The ESM and EFSF can purchase government-issued bonds in on the secondary market, helping to lower the borrowing costs of fiscally weak EU nations. Prior to this agreement, the bailout funds were set up to lend money directly to governments in exchange for strict austerity measures.

Stock markets rallied in the wake of these announcements and yields on Italy and Spain’s sovereign debt declined sharply, as this plan would dramatically reduce the odds that Europe’s troubles will escalate into a global credit crunch.

But investors should also remember that this plan isn’t the first response to the EU sovereign-debt crisis. Previous solutions have proved only temporary. The latest agreement also leaves plenty of questions unanswered.

For one, the EUR800 billion at the ESM’s disposal includes the EUR300 billion that the EFSF already lent to countries requesting bailouts. This EUR500 billion in new capital may prove insufficient to support Spain’s USD1.4 trillion economy and Italy’s USD2.1 trillion economy.

Moreover, Finland and the Netherlands plan to block measures that would allow the ESM to purchase sovereign bonds on the secondary market. At the very least, this discord indicates that EU leaders remain deeply divided as to how to address the crisis.

The deal also stopped short of further fiscal integration, including the creation of a common EU sovereign bond or a central system for guaranteeing bank deposits.

Moreover, Europe’s economy remains mired in at least a mild recession, while Italy and Spain’s economic growth will remain constrained by tax hikes and cuts in government spending.

Source: Energy Information Administration

As in the US, European oil demand has languished since the 2007-09 financial crisis. According to preliminary IEA data, oil consumption in Europe’s developed economies tumbled by about 400,000 barrels per day in the first four months of 2012, paced by a 14.9 percent drop in Italy, a 7.8 percent decline in Spain and a 16.5 plunge in Greece.

We expect EU oil demand to fall through the rest of 2012, though the year-over-year rate of decline should slow in the second half because of easier comparisons. Investors shouldn’t be surprised if European oil consumption tumbles by 300,000 barrels to 400,000 barrels per day.

These modest declines in US and European oil demand–a scenario that’s more than reflected in prevailing oil prices–should be more than offset by rising consumption in Brazil, China, India and other emerging markets. The IEA estimates that non-OECD oil demand in April 2012 climbed by about 900,000 barrels per day from year-ago levels.

Speculation that China’s economic growth will slow relative to prior years has driven the recent weakness in oil prices. China’s GDP growth has slowed to an annualized rate of 8 percent from 11 percent in early 2011, while China’s PMI slipped to 50.2 in June, down slightly from 50.4 in May.

HSBC Holdings (LSE: HSBA, NYSE: HBC) published an alternative PMI for China that includes more data from smaller firms. This index came in at 48.2 in June, suggesting that smaller firms in China are struggling relative their larger counterparts.

But investors forget that China’s economic slowdown largely stems from Beijing’s efforts to rein in inflation. The government steadily increased banks’ reserve requirement in 2010 and early 2011. As these efforts brought inflation in check, Chinese authorities have reversed course, slashing reserve requirement ratios three times since late 2011 and reducing interest rates in June. These stimulative moves have revived residential real estate lending, with mortgage volumes in May surging 8.5 percent year over year.

Source: Bloomberg

As you can see, loan volumes have picked up somewhat in China since late last year, and analysts expect the data for June to exhibit another surge from year-ago levels. Policymakers have signaled their willingness to implement additional growth initiatives, likely in the form of interest rate cuts and further reductions to banks’ reserve requirements.

A stimulus similar to China’s 2008-09 spending spree probably won’t be in the cards, but Beijing could approve a smaller package if the global economy were to falter.

At any rate, China’s oil demand hasn’t slowed. Oil imports hit a record high in May.

Source: Bloomberg

The Supply Side

Oil supply growth from countries outside OPEC should grow by roughly 660,000 barrels per day, with North America accounting for much of this uptick in production. Preliminary data from the US Energy Information Administration indicates that domestic crude oil production in April surged by 567,000 barrels per day from year ago levels. Robust drilling activity in unconventional plays such as the Bakken Shale in North Dakota and the Eagle Ford Shale in south Texas fueled much of this growth.

Source: Energy Information Administration

US crude oil production is rising for the first time since the 1980s, a sea change that’s reduced the nation’s dependence on oil imports. Even better, the US now enjoys lower energy prices than any other major developed economy in the world.

However, investors should disregard the fallacious argument that global oil prices will decline because of surging output from US shale plays. There’s an old saw in the energy industry that it’s harder to grow oil output than gas production.

Let’s put the increase in US oil production in context. Current oil production amounts to about one-third of domestic demand; the nation is a long way from altogether weaning itself off foreign oil.

In contrast, the US is already the world’s largest producer of natural gas and doesn’t require imports to meet domestic demand; in fact, the country will likely become a significant exporter of natural gas before the end of the decade.

The increase in crude oil production witnessed over the past few years has been far from easy or inexpensive. Over the past decade, the number of wells drilled for crude oil in the US has surged from between 500 and 700 wells per month to well north of 2,000 wells per month.

Source: Energy Information Administration

Much of this acceleration in drilling activity has occurred over the past three years. More than 1,300 rigs are actively drilling for crude oil in the US, up from a 2008 peak of just 426 rigs.

US oil production could ramp up even faster in coming months, as development accelerates in the deepwater Gulf of Mexico. However, if oil were to trade in the low to mid-$70s per barrel, producers would likely moderate output because of cost inflation.

The picture is far less rosy outside North America. According to the IEA, unplanned production outages in non-OPEC nations totaled almost 1.3 million barrels per day in the second quarter.

For example, output from the North Sea has declined because mechanical problems, a gas leak in the Elgin field and labor strikes. Meanwhile, a production transportation dispute between Sudan and South Sudan has brought oil output to a standstill, while production in Yemen and Syria has declined because of civil unrest and sabotage to crude oil pipelines.

Although outages related to oil sands production in Canada are fading and North Sea production should normalize in the second half of the year, outages will still total more than 1 million barrels per day by the end of 2012.

With rising oil demand outpacing non-OPEC supply growth, the world depends heavily on OPEC production to balance the market. To date, OPEC has flowed more than enough oil to meet demand.

Source: Bloomberg

Overall, OPEC oil supply was up 2.25 million barrels per day in June, led by an increase in Libyan oil output from less than 300,000 barrels per day a year ago as the country’s production recovers from last year’s civil war. Recent data suggests that Libyan output is now close to its pre-war level of 1.6 million barrels per day and the nation has recovered surprisingly quickly from last year’s outages.

But Saudi Arabia has also been an aggressive producer so far in 2012, with output topping 10 million barrels per day in each of the past three months–up about 1.1 million barrels per day from the same time last year. Some of Saudi Arabia’s excess production represents efforts to boost oil supply to offset the impacts of sanctions against Iran that went into effect starting on July 1. Iran has maintained production to date, but much of its output is flowing into storage, with exports down about 1 million barrels day since the end of 2011. At some point sanctions will negatively impact the country’s ability to export crude oil and storage will fill up, forcing the nation to cut actual production.

Saudi Arabia is unlikely to maintain production at recent levels if Brent oil prices were to continue to fall significantly under $90 per barrel. And the nation may slice output given the pick-up in Libyan production or if it feels Iranian output will be stronger than the market expects. Prices around $100 per barrel on Brent appear comfortable for Saudi Arabia as they’re high enough to generate considerable profits but low enough to limit the impact on global demand. Moreover, to increase its production, Saudi Arabia has simply dipped into spare production capacity; OPEC spare capacity continues to hover at under 3 million barrels per day, with about 1.9 million barrels per day of that capacity in Saudi Arabia. OPEC’s spare capacity position is tighter than it was at the same time last year; in May 2011 spare capacity stood at about 4.4 million barrels per day.

In June, OPEC oil supply increased by 2.25 million barrels per day from a year ago, led by the recovery in Libya’s oil output as the country emerges from last year’s civil war. Recent data points suggest that Libyan production has approached its prewar level of 1.6 million barrels of oil per day.

Saudi Arabia has also ramped up production, with output topping 10 million barrels per day in each of the past three months–up about 1.1 million barrels per day from a year ago. Some of this production increase reflects efforts to offset sanctions against Iran.

Iran has maintained its oil output thus far, but much of this production is destined for storage. At some point, available storage capacity will fill up, forcing the nation to cut production.

Saudi Arabia is unlikely to maintain current production if Brent crude oil were to decline to less than $90 per barrel for an extended period. However, the Kingdom could cut output if Iranian oil production exceeds expectations.

OPEC’s spare productive capacity continues to hover around 3 million barrels per day, compared to about 4.4 million barrels per day in May 2011. Saudi Arabia accounts for about 1.9 million barrels per day of this spare capacity.

Still Tight

US inventories of crude oil have swelled because of a glut in Cushing, Okla., the official delivery point for WTI. US crude oil stockpiles stand at 387.2 million barrels, up almost 8 percent from a year ago, while the oil supply at Cushing has ballooned by 26.4 percent.

Meanwhile, gasoline inventories slipped about 4 percent on a year-over-year basis, while inventories of distillates–diesel and heating oil–are down roughly 20 percent. 

This surfeit of oil accounts for the widening price differential between WTI and Brent crude oil. Enbridge (NYSE: ENB) and Conservative Portfolio holding Enterprise Product Partners LP (NYSE: EPD) recently completed their reversal of the Seaway Pipeline, which should alleviate this bottleneck by transporting oil to the Gulf Coast from Cushing. But the pipeline doesn’t yet operate at its nameplate capacity, and it will take time to work through excess supplies.

Far too many investors extrapolate the US experience to other regions of the world; most major oil-consuming nations face tighter inventories, a trend that’s evident in the shape of the Brent crude oil futures curve.

Brent futures for August delivery trade at $96.30 per barrel, but futures expiring in six months fetch $95.75 per barrel. When near-term futures command a higher price than futures expiring further into the future, the market is in backwardation.

Currently, the market for WTI is in contango. That is, near-term oil futures trade at a discount to longer-dated contracts. This imabalance suggests that supply shortfalls are unlikely in the near term, which is why spot prices are relatively low. Markets in contango also encourage traders to purchase oil for storage in the spot market and sell that at higher future prices.

In contrast, backwardation indicates a tight supply-demand balance in the near term.

The contrast between the shape of the futures curve for Brent and WTI speaks volumes about supply and demand conditions in these two markets. In particular, the US market is relatively well-supplied, while the balance in Europe and Asia look tight despite softening demand.

The fundamentals in the global oil market haven’t shifted to the extent suggested by the recent decline in prices. Investors have fixated on the potential for a global economic slowdown to reduce crude oil demand, but emerging-market consumption remains robust. The decline in EU oil demand won’t have much of an impact on the global market.

Unless the US joins Europe in recession–an unlikely scenario–global demand growth will likely exceed non-OPEC supply, leaving OPEC to fill in the gap. We don’t expect Saudi Arabia and the rest of OPEC to maintain production at current elevated levels if prices decline further.

QE3, Inflation Expectations and Oil Prices

The Federal Reserve will likely announce a third round of quantitative easing (QE3)–buying government bonds to drive down interest rates–in August or September.  Such a move would strengthen stock and commodity prices, a bullish development for many of our Portfolio holdings.  

Whereas quantitative easing effectively creates money and forces that cash into the economy, the Fed’s Operation Twist plowed the proceeds from maturing short-term bonds on the central bank’s balance sheet into longer-term issues. This unconventional monetary policy sought to drive down longer-term interest rates that serve as a baseline for pricing mortgages and other loans.

When the Fed announced the extension of Operation Twist through the end of 2012, the central bank also disclosed plans to purchase $267 billion worth of Treasury bonds that mature within six years to 30 years. Funding for these purchases will come from the sale or redemption of securities that mature within three years.

Investors can monitor quantitative easing by tracking the size of the Fed’s balance sheet. Since the end of 2007, the Fed’s balance sheet has more than tripled to $2.8 trillion worth of assets. These holdings include $18.5 billion in short-term Treasury bills, $1.57 trillion in Treasury notes and bonds, about $68 billion in Treasury inflation-protected securities, about $91 billion in bonds issued by Fannie Mae and Freddie Mac, and more than $850 billion in mortgage-backed securities.

Fed Chairman Ben Bernanke and others have provided a handful of justifications for the central bank’s quantitative easing, from pushing down long-term interest rates to pushing up stock prices. But the Fed’s primary goal is to stem deflationary pressures at all costs.

On Nov. 4, 2010, the Washington Post ran an op-ed piece by Ben Bernanke that explained the rationale behind the Fed’s second round of quantitative easing:

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy–especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009.

An avid student of the Great Depression, the Fed chairman is determined to prevent the US economy from slipping into deflation once again. The head of the central bank would prefer an inflation rate of 2 percent to 3 percent, as opposed to a downward trend in consumer prices. By printing money to purchase bonds, the Fed stimulates inflation.

Quantitative easing is a controversial policy among academics, policymakers and the public. The same is true of the Fed’s focus on preventing deflation at the risk of promoting higher inflation or a weak US dollar. There’s no shortage of opinions on this matter.

Rather than add to the noise by voicing my opinion on the merits of these efforts, I prefer to focus on what matters to investors: How policymakers and the Fed think about quantitative easing and how this will guide their actions. In the financial markets, we profit from probabilities and careful analysis, not opinion and political rhetoric.

Given the Fed’s interest in preventing deflation, it’s important to keep your finger on the pulse of investors’ inflation expectations.

The five-year, break-even inflation rate compares the yield on a five-year US Treasury bond to the yield on a five-year Treasury Inflation Protected Security (TIPS), a bond issued by the US Treasury where the principal adjusts based on the value of the Consumer Price Index (CPI). This yield spread reflects the market’s expectations for inflation over the next five years.

Source: Bloomberg

The market began to discount the potential for outright deflation at the height of the financial crisis in 2008-09, with the yield spread between the five-year US Treasury bond and five-year TIPS plummeting to negative 2 percent in late 2008 and early 2009 from 2.75 percent in mid-2008.

As the initial snapback from the 2007-09 recession faded in early 2010, inflation expectations tumbled once again. By summer 2010, many pundits predicted that the US would suffer a double-dip recession and a second credit crunch emanating from Europe. In August 2010, the Fed hinted at the potential for another round of quantitative easing and made the official announcement a few weeks later. This news prompted expectations of inflation to rise.

This pattern played out last summer, with the Fed instituting Operation Twist to bolster the outlook for inflation.

This time around, the central bank has already extended its program of swapping short-term bonds for those with longer maturities. But we expect the Fed to take further action.

As we’ve predicted since March, US economic data have softened markedly. The unseasonably warm winter artificially boosted activity, making the US economy look stronger than it otherwise would have appeared. Retail sales, construction activity and hiring that would have occurred after the annual spring thaw in April and May were pulled forward.

Spillover from the EU’s intensifying sovereign-debt crisis, elevated oil prices and uncertainty about US fiscal and tax policies in 2013 have also contributed to US economic weakness. Particularly troubling is the June reading of the Institute for Supply Management’s Purchasing Managers Index (PMI), a measure of strength or weakness in the manufacturing sector of the US economy. 

The June PMI reading came in at 49.7–the first time the index breached 50 since 2009. This number was also well below analysts’ consensus expectations of 52.

PMI is a diffusion index: Readings greater than 50 indicate that manufacturing activity expanded, while values below 50 suggest contraction. In practice, a PMI reading of 45 or 46 is consistent with a recession, while temporary dips to the high 40s don’t necessarily reflect an economic contraction.

The new orders component of PMI is of greater concern to investors, which serves as a leading indicator of future manufacturing activity, plummeted from more than 60 in May to 47.8 in June.

Softness in the US economy, coupled with declining expectations for inflation, should prompt the Fed to implement QE3. Two years ago, Ben Bernanke used his annual August speech in Jackson Hole, Wyo., to announce the second round of quantitative easing;  don’t be surprised to if he at least hints at QE3 this year.

Although the odds of a US recession have increased in recent months, we expect the economy to skirt an outright contraction. Fading seasonal headwinds, the drop in oil prices and the latest plan to address the EU sovereign-debt crisis should support the economy. Moreover, another summer swoon increases the likelihood that US lawmakers will reach a compromise that prevents some of the pending tax hikes and spending cuts. However, such an agreement won’t occur until after the presidential election.

The announcement of QE3 would support oil prices. Check out this graph tracking the relationship between oil prices and the break-even inflation rate on five-year bonds.

Source: Bloomberg

Before the financial crisis, oil prices usually climbed when expectations for US inflation declined; a reasonably strong economy and low expectations for inflation reduces the odds that the Federal Reserve will raise interest rates. In the old normal, low expectations for inflation were regarded as a positive indicator for the US economy.

In contrast, declining expectations for US inflation are less desirable when the economy languishes, as the risk of disinflation and economic weakness increases. The lackluster economic growth that’s come to characterize the new normal means that oil prices tend to decline when expectations for US inflation wane. 

The Verdict

Many moving parts influence oil prices, including the outlook for US inflation, expectations for China’s economic growth and conditions in European credit markets. Accordingly, forecasting oil prices is an exercise in probability, not an exact science.

In the first issue of 2012, we called for oil to retest its 2011 high and average between $100 and $110 per barrel on the year. Our full-year outlook hasn’t changed.

Over the next few months, we expect oil prices to follow the stock market. Although the S&P 500 found a low in early June and has rallied sharply since the EU summit in late June, we expect further signs of economic softness in the US to catalyze another selloff this summer.

The stock market and oil prices rarely carve out a v-shaped low; a more normal pattern is for prices to retest their lows before embarking on a durable rally, a w-shaped bottom. Brent crude oil prices have exhibited this pattern in recent years.

Source: Stockcharts.com

During summer swoon of 2010, the oil benchmark tested its resistance point at $70 per barrel on three occasions between before rallying to a new 52-week high before the end of the year. Last summer, Brent crude oil found support at $100 per barrel before rallying more than 30 percent into early 2012.

Brent crude oil touched its current low of $88.49 per barrel in June and subsequently rebounded to more than $100 per barrel. Over the coming few months, we expect Brent crude oil to pull back and revisit this low. If oil slips to these levels, we will consider adding US Oil Fund (NYSE: USO), which tracks WTI prices, or United Stated Brent Oil Fund (NYSE: BNO) as a short-term trade. In the event that this opportunity materializes, we will notify subscribers via a Flash Alert.

Movements in the Chicago Board Options Exchange Market Volatility Index (VIX), which quantifies anticipated volatility in the S&P 500, will also inform our near-term outlook and strategy. High VIX readings indicate rising fear and panic among investors, which often corresponds to a bottom in the stock market or commodity prices.

Source: Stockcharts.com

In each of the past two summers, the VIX climbed into the upper 40s before S&P 500 hit its bottom. But in early June 2012, the VIX didn’t even eclipse 30, as investors shrugged off rising yields on EU sovereign bonds, concerns about US and China’s economic growth and uncertainty surrounding US tax and fiscal policy after the presidential election.

Although the VIX had retreated since EU leaders announced a plan to address the Continent’s debt crisis, we doubt that the stroke of a pen effectively erased concerns about the health of the global economy.

But our six-month outlook for oil and equities is more sanguine. After a few growth scares this summer, we expect the US economy to strengthen into year-end and the US, China and Europe to implement additional monetary stimuli. US lawmakers will also achieve a compromise that removes some of the tax hikes and spending cuts slated to go into effect.

All these factors should enable Brent crude oil to exceed $110 per barrel by year-end. In this scenario, WTI will rally to more than $100 per barrel.

What could derail this bullish outlook?  If US economic data fails to improve this summer and the nation joins Europe in recession, Chinese authorities would have a tough time preventing their economy from slowing dramatically. This chain of events would produce a global recession, depressing Brent crude oil to the $60s per barrel. We regard this bearish scenario as an unlikely outcome.