Oil Storm Beckons

Commodity deflation has arrived as evidenced by tumbling energy products and base metals. The tightening global liquidity situation as evidenced by the outflows from emerging markets and below-trend growth for developed economies show that the economic outlook is unlikely to pick up in the near-term. As such, it is apparent that commodity prices will remain lower for longer, much to the dismay of exporting nations struggling to balance budgets. Oil prices in particular are set to remain subdued owing to the persistent oversupply conditions as exporters race to increase production to offset the losses in revenue. However, these very actions to protect market share and revenues have in many ways caused the spiral lower in prices.  Although there has been a near-term rebound after WTI prices hit a multi-year low, the bounce is likely to be short lived due to a number of external factors.

The Fundamental Perspective

Oil prices are sensitive to numerous influences from both the supply and demand side. From the viewpoint of economics, the intersection of supply and demand is known as equilibrium, or the price at which all production supplied is consumed (or demanded). The supply conditions remain one of the major drivers of prices as evidenced by recent rig count data combined with inventory numbers from the United States. From a production standpoint, the United States has seen lower oil prices hardly dent output which remains not far from multi-decade highs. Even though production has fallen to the lowest level in months, the United States remains in the top three spots of major global producers and shows no signs of increased deceleration in output.

Supply from the shale patch has remained high as companies faced with imminent defaults and bankruptcies keep production high to maintain financial lifelines.  However, the longer prices stay lower, the more companies are likely to bow out from the industry, leaving great opportunities for the vulture financial firms waiting for bargain basement prices on productive ground.  With many firms facing similar difficulties, the next few months will prove critical for the resurgence of the American oil industry. Revolving credit lines are likely to expire and not be renewed as banks pull back the reigns on financing.  However, despite the prospective weakness in the pipeline for the American oil industry, it is not the only nation contributing to the persistent oversupply issue.

OPEC continues to pump well beyond output targets set by the group as members defect and protect their own interests instead of using the cartel to keep prices stable and higher.  While there have been calls from members for emergency meetings to spread output cuts across the group, these requests have been largely ignored by the bigger producers including Saudi Arabia and Kuwait.  Moreover, the Iranians have expressed an interest in increasing oil production and exports, a move that might deal a crushing blow to any price recovery.  Supply continues to outpace demand by 1.5-2.0 million barrels per day, a situation that will be further exacerbated by additional output hitting global markets. 

With demand currently stable at approximately 93 million barrels per day, no significant uptick in demand is likely to translate to lower prices as supplies continue to eclipse demand.  If anything, demand is showing further signs of slowing as evidenced by the massive crude oil inventory build recorded last week.  After tumbling by nearly 5.5 million barrels in the prior week, inventories surged higher, climbing over 4.6 million barrels in the latest reporting period, highlighting another potential slowdown in refinery demand. Although the collapsing rig count has provided some support for prices, the impact is just temporary with drill rigs tumbling for the last 6-weeks, falling to 662 according to the latest Baker Hughes data.  Without a change in the supply and demand fundamentals, there remains no strong catalyst for higher crude oil prices in the near-to-medium term.

The Technical Take

Last week saw oil prices experience a tremendous bounce to the upside, very much reminiscent of a short squeeze after prices hit the lowest levels since 2009.  With capitulation largely occurring, the technical pullback to the upside is current underway, helped along by the fact that the short positioning had hit such a level that a squeeze was inevitable. The rebound was further aided by the plunging rig count, however, with WTI crude oil prices currently consolidating, a breakout trade might be around the corner. The bias from a technical perspective to the downside is of a similar vein to that of the longer-term fundamental perspective. With oil prices firmly below both the 50 and 200-day moving averages, downside risks to the outlook remain with a retest of recent lows very possible.

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Prices are currently consolidating within a triangle pattern bound by a medium-term downtrend and short-term uptrend. Based on the confluence of these trendlines, crude oil is currently trading within the range. The ideal way to take advantage of the setup is wait for the breakout trade which will likely be accompanied by renewed directional momentum. Taking Call positions from the bottom of the triangle and Put positions from the top of the triangle is not necessarily suggested due to the narrowing of reward conditions over time and substantially increased risks.  Ideally, if the downtrend line is broken, it would be prudent to initiate Call positions with targets set at $49 per barrel while a break below the uptrend line would merit Put positions targeting $40 per barrel and lower.  On a longer-term trading horizon however, upticks in crude oil should be viewed as a strong entry point for Put positions targeting new multi-year lows in the energy benchmark.

Conclusion

Conditions in global energy markets are unlikely to make a dramatic shift in the coming months despite the risks for the industry which is suffering under the weight of lower prices. However, the ability of certain producers to ramp supply further despite the propensity of others to have to cut back on output means that existing oversupply conditions are likely to remain.  With demand staying largely constant, a serious shift in supply will be the only solution to falling prices. However, with dissent in OPEC high and United States output not harmed as much as previously thought by the price war, prices are likely to remain lower for longer.  With the technicals currently screaming further downside, the longer-term outlook for prices continues to see risks mainly to the downside.  While short-term might see opportunities for Call positions, fading rallies with Put positions is a sound strategy for taking advantage of the weakness.