Weekly Wrap: Oil and China

Sunday April 16, 10:58 pm ET
By Jonathan Bernstein, ETFzone Trading Specialist

Two key news items for the macro-thinking ETF investor this past week: the Chinese economy is expanding faster than expected andÂ… crude oil is trading higher.

More specifically: China's GDP expanded at a rate of 10.2% in the first quarter of 2006, and crude oil closed Friday just shy of $70 a barrel, at $69.85. How are these two events related? Consider the 1-year chart of the "Chinese ETF," iShares FTSE/Xinhua China 25 Index (NYSE:FXI - News) and a key oil fund, the Energy Select Sector SPDR (AMEX:XLE - News).

Although FXI and XLE over the last twelve months have diverged, the two ETFs appear to be well correlated. One reason for the correlation may be that as the Chinese economy expands, Chinese demand for oil increases. And with crude supply relatively constant (and tight), the increase in demand causes the price of oil to climb. Of course, there are plenty of other forces acting on the oil market-- supply disruptions and demand fluctuations. Certainly these may prove to be more important than any China link.

But possible correlation between the performance of the Chinese economy and the price of crude may be interesting for ETF investors in part because China is not always mentioned as a factor in higher oil prices. For example, most explanations for higher oil this week involve the U.S. demand for gasoline as summer driving season gets underway, and the threat to pipelines in the Middle East.

So what is the trade?

At $69.85 a barrel, crude is just a dollar shy of its all-time high, set when traders reacted to hurricane Katrina in August of last year. XLE is now trading higher than in August, but is still about 4% off its all-time high.

Although pressure to slow the growth of the Chinese marketÂ--now the four largest in the worldÂ--may increase, at least in the short run demand for oil in China does not yet seem to be faltering. This is good news for investors in oil infrastructure (XLE) as well as the underlying commodity. A new ETF, the US Oil Fund (AMEX:USO - News), provides investors wit the opportunity for a direct investment in crude.

And, on a more near-term basis XLE has been lagging FXI. The chart below compares FXI and XLE on a 3-month basis.

As the chart above shows, on a 3-month basis XLE has underperformed relative to FXI. This makes XLE seem attractive relative to FXI.

Possible correlation between FXI and XLE may provide investors with another data point when making buy and sell decisions, as well as help to develop partial hedge positions in these funds.