Why Technical Developments Shouldn’t be Ignored
This is a little addendum to our recent comments on the crude oil market (which you can see here, here and here, in chronological order). Apparently Goldman Sachs just published a research report calling for $20 oil – which strikes us as a bookend to their infamous $200 call in 2008, which preceded the ultimate peak at $149 by just one or two weeks if memory serves (readers may remember this call by GS – it did get a lot of press at the time).
The recent sharp reversal after a seeming break of support definitely deserves attention, especially as everybody seems certain that after having declined some 75% from its peak, the price of oil can only go down further. Obviously, no such certainties were in evidence anywhere near the peak or when WTI crude was still trading near $100 a year ago (even though the supply-demand situation had quite obviously deteriorated gravely already).
WTIC crude, weekly – a lateral support level was broken amid a price/RSI divergence, and then prices reversed back up. There hasn’t been any follow-through buying since then, so this reversal may yet fail, but it seems to us that the market is ripe for an upward correction even if the longer term bear market isn’t over yet – click to enlarge.
Anyway, we wanted to briefly come back to the reasons why we think such technical signals shouldn’t be ignored. For one thing, experience shows that price lows are put in long before the “fundamentals” indicate they should. In fact, price lows are routinely put in while the fundamental backdrop is seemingly still at its very worst. This is so because market prices are discounting negative fundamentals in advance to some extent; so even though the fundamental backdrop may still get worse, it offers no guarantee that prices will go even lower.
For another thing, nominal commodity prices are not only a function of the supply-demand fundamentals of the commodity concerned – they also reflect the amount of the money in the economy. If that were not so, crude oil might as well go back to $1,20, where it traded in the late 1960s/ early 1970s. In late 1998, crude oil traded at roughly $10 (then an 18 year low). Since then, the US money supply has roughly quadrupled.
Market Structure Belies Supply-Demand Statistics
Lastly, the global supply-demand statistics published by various bodies such as the IEA are not the holy grail, i.e., they aren’t entirely immune to error. One way to confirm or refute these statistics is the futures market curve, which should reflect the supply-demand situation in its contango. It is this particular point that is of interest to us here. As we have previously noted, the contango is currently not as big as one would normally expect if the market were as wildly oversupplied as is widely asserted. Now Reuters reports that various shale oil spot markets are trading well above the futures curve. Moreover, supply at Cushing keeps “defying expectations” by declining week after week, and the contango keeps contracting:
“In shale strongholds of North Dakota and Texas, physical crude grades are trading at the highest premiums to futures prices in years, offering a glimmer of hope that a pickup in global oil markets might follow. While crude futures hover around 6-1/2-year lows, the cash markets, where producers and refiners buy and sell physical barrels of oil, are sending a more optimistic, if short-term, signal.
West Texas Intermediate crude delivered to Midland, Texas WTC-WTM, at the heart of the Permian Basin, is trading at a record $2.75 premium to benchmark U.S. futures. North Dakota’s Bakken crude WTC-BAK fetches more than 50 cents more, the highest in two years. The two areas produce more than 60 percent of U.S. shale oil.
Many cash crude traders say the relative strength of these markets most likely reflects local, short-term factors: newly built pipelines in Texas are increasing demand for local crude, while Midwest refiners are snapping up Bakken supplies following unexpected month-long outage in Canada.
But as the gains persist, some are wondering if that could also be a sign that a year-long supply glut is beginning to ease, helping put a floor under world prices that have tumbled to their lowest since 2009.
They point out that supply at Cushing, Oklahoma – the delivery point of the U.S. futures contract – continues to fall, defying expectations it would keep rising because of weak demand, refinery closures and maintenance season shut-downs. Instead, stocks at Cushing have fallen in five of the past seven weeks as operating refiners bid aggressively for dwindling supply of crude. “Supply for light (crude) in Cushing is tight,” said one trader.
For months, the U.S. market has been gripped by fears that Cushing may run out of space as traders were choosing to store they supplies rather than sell on holding out for prices to rebound. That has prompted traders to roll over futures contracts to later deliveries making those more expensive.
Now the negative spread between front and second month U.S. oil crude contracts has narrowed to about 50 cents CLc1-Clc2, instead of blowing out to more than $1 as earlier expected.
It is of course legitimate to look for reasons for unexpected developments such as the above mentioned “local short term factors”; no doubt they do play a role in the premium that has emerged in the shale oil spot markets. However, our experience is that it is usually best not to over-analyze market signals in an attempt to prove why “this time is different”, because most often it turns out that it isn’t.
In the short term, market moves are often driven by traders’ emotions. However, the market structure, i.e., contango and backwardation in futures, is usually quite informative. Traders driving the short term price action tend to concentrate on the most liquid nearby futures contract. The differentials that form as one looks further along the curve are probably the result of more deliberated activity. If higher prices are paid in the spot market than for the nearest future, it is always meaningful, because the spot market reflects the actions of actual producers and users of the commodity.
Lastly, positioning data in currencies still show a strong commitment by speculators to a rising dollar, even though the dollar has gone nowhere in several months. The speculative long positions in dollar index futures, resp. the short positions in the most important component currencies making up the index are off their highest points, but still remain historically quite large. These positions are increasingly “stale” and could begin to weigh on these markets if the previous trend isn’t resuming soon. A weaker dollar would undoubtedly be supportive for commodity prices.
It is also worth noting in this context that the Russian ruble (one of the major “oil currencies”) has just put in its first higher low since its downturn began in May (= a lower high in USD-RUB):
The ruble is giving us a hint – click to enlarge.
There continue to be many reasons to expect various industrial commodities, including crude oil, to at least produce a sizable retracement of their steep price declines. Keep also in mind that in addition to the factors discussed above, rare extremes in negative sentiment have been recorded in recent weeks (surveys such as Market Vane, the DSI/ daily sentiment index or Consensus Inc. all have reported historical extremes in bearish sentiment). In the past, such readings have invariably occurred in the vicinity of price lows of at least medium term significance.