A lesser known disruption in the markets may be at the heart of crude's strong move over the past six weeks. After hitting a recent low of $75 per barrel on October 4, spot WTI oil prices have rallied $25 to now topping $100 on Wednesday. Besides the usual catalysts that flow quickly from energy pundits' lips like Middle East tensions, refined product shortages, and the strength of the dollar; we direct your attention to letters of credit (LoC) and European banks.
Previously, the Wall Street Journal highlighted that trade finance in the form of letters of credit (LoC) facilitated by European banks was an underpinning for trade into China and abroad. It was further emphasized that a shortage of LoC availability would lead to a slowing of trade. So, now that European banks are embroiled in a sovereign debt crisis, their need to raise reserves is in fact diminishing their capacity to extend letters of credit to exporters of all goods, including crude oil.
Thus, part of the explanation of why oil prices have climbed so rapidly can be attributed to the deterioration of Europe and its impact on trade supply. This would make for a short-term phenomenon where oil prices would reset lower once the crisis has passed. As can be seen by the following graph, relative to the U.S. broader market (as measured by the S&P 500 Index) the price of spot WTI crude is trading at premium levels not seen since the beginning of the Arab Spring.
While trends tend to last longer than market participants anticipate, the shrinking ratio between the S&P 500 and crude prices should make one pause before jumping on the bullish bandwagon that has picked up momentum over the past month.
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