A Crude New Day
Crude oil has been a great trading market since its massive sell-off in 2014 that took it from above $100 per barrel to — at one time, OK, twice — under $30. It has traded in a stable, predictable range while also providing huge price movements. While that last comment may seem conflicting, it is not, as crude breached a long-term trendline and then straddled it for the better part of three years, creating significant and numerous price swings (see “Crude pivot,” below).
The longer-term trendline served as a barometer, especially at month-end, for the price of crude. It was a long-term pivot. When initially breached in January 2015, crude rallied sharply in the last hour of the last day of the month to settle above it and to highlight its significance. This led to a sharp corrective move higher to $62.58, which served as the top of a broad range for the market that lasted until very recently.
In June 2017, crude oil began a rally that would eventually breach the May 2015 corrective high (see “Resistance is futile,” below). The market has since retreated following the more than 50% move during six months, but the big question for traders is, “Has there been significant technical damage?”
Howard Marella, president at Icon Alternatives, says, “It has done some technical damage because it did break above the old high from 2015, and that was the last top since we had broken down under the $100 level.”
Jason Rotman, president of Lido Isle Advisors, also says that taking out the 2015 high is a significant technical benchmark. “This bear market, where all the rallies were passionately sold because of supply, is over,” Rotman says. “I don’t think it is a real bull market yet, even though we had a tremendous rally off of the lows. The market is probably going to stabilize anywhere from $55 to $75.
While the breach is real and can lead to further upside in crude oil, nearly everyone expected the 50% move to experience a correction. “Whenever you go up this much you have to be on guard for a correction,” says Phil Flynn, senior energy analyst at The PRICE Futures Group. “If you compare crude to the price of the stock market, crude has a lot more to go because the relationship has been out of whack.”
Marella adds, “Prices have gotten a little frothy. It looked like it was going to test $70, [but] it will keep under there. Near-term we will see choppiness in all markets.”
Dominick Chirichella, partner at Energy Management Institute, says a near-term top has been made. “Short- to medium-term, it is a top right now [at] $65. We broke the upward trend that started in June,” Chirichella says. “Technically, we can drift lower and fundamentally we can drift lower before we get back into a sustained rally.”
Supply & Demand
Most analysts expected a retreat from the massive six-month rally, which did occur, but the levels breached indicate that crude can eventually go higher if the fundamentals cooperate. That is the key. Where the conflict exists among analysts’ opinions, is surrounding the fundamental basics of supply and demand.
Crude has remained relatively low for several years because of a stubbornly high inventory level that it has been working off over the last year (see “Working off the excess,” below).
Paul Kuklinski, founder of Boston Energy Research, says oil prices have limited upside. “It has gone up too much too soon; the increase in oil prices since August [has stimulated a] strong production response, sufficient to keep oil inventories elevated above the five-year average for all of 2018 despite the extension of OPEC production cuts to the end of the year.”
Flynn has been a bull for some time and expects both the supply and demand side to support higher prices. “The reason why the oil bears have had it wrong is that they underestimated demand, they overestimated production and they underestimated the ability of OPEC to adhere to production cuts,” Flynn says. “If you go back a few months ago, the bearish argument was that OPEC was going to cheat and then the shale producers will come back online and this thing would blow up. It never happened.”
He adds that at the bottom of the cycles, we cut back more than $1 trillion in capital spending, and you can’t replace that with shale oil production.
However, at the bottom of the cycle, crude oil was trading under $30. Producers have proved to be more resilient than in the past and have ramped up rig counts at crude oil price levels previously thought to be short of breakeven.
“Changes in inventory are the largest factor on crude oil prices,” Kuklinski says. “Right now in the very short term, the bias is downward on crude oil before we start to get seasonals kicking in; when you get a seasonal ramp up in world oil demand, [we will] see how non-OPEC and U.S. supplies are responding.”
Higher prices don’t only allow producers to earn a little extra, they allow them to hedge that production, which provides confidence to drill. “If we are an oil company that can make money at $40 (per barrel) and now crude oil is up to $60-$65, what are we going to do? We are going to hedge everything we got for 2018 and drill like crazy,” Kuklinski says.
Not only has supply come under control, but the other side of the equation, demand, is becoming more relevant. For years, crude has been driven by supply and a stubborn glut, but the global economy is growing, which means more demand.
“People said shale production would go up and OPEC would cheat. We started to see evidence right away that compliance was good on the production cuts and the prices just went down to July,” Flynn says, adding, “Europe is starting to consume a lot of oil.”
While OPEC compliance has held, and OPEC agreed to extend production cuts through 2018, Chirichella says there has been some structural damage on the fundamental side. “[With U.S.] production at 10.52 million (barrels per day), the trajectory looks like it will go to 11 million, and that’s damaging. After a lengthy period of destocking going back to last February, we seemed to have turned the corner.”
Kuklinski bases his outlook on production by the Organization for Economic Co-operation and Development (OECD) countries, which exclude OPEC and Russia. “Inventories are hard to track in the non-OECD world. OECD will drive changes, all things being equal,” he says (see “More oil,” below).
Flynn adds that Energy Information Administration (EIA) production estimates are overstated.
Another thing to ponder his how much of the rally can be attributed to dollar weakness.
In fact, the weak dollar may have been holding the crude oil market up for a time as it began to falter at the beginning of 2017, and crude did not begin to rally until mid-2017.
There is a great deal of debate regarding the correlation between the dollar and crude oil. It is a mistake to view crude and the dollar as perfectly negatively correlated because there are numerous fundamentals for energy unrelated to the dollar. However, crude is priced in dollars globally, so movements in the dollar affect the real value of crude. Weakness in the dollar reduces, in real terms, what producers get paid for oil. When the dollar was rallying sharply in 2014, it opened up more downside for crude, but the underlying fundamentals still needed to warrant the sell-off (see “Dollar/crude dance,” below).
“The weak dollar certainly contributed to it, and rising equities,” Chirichella says. “We had a hell of a rally in equities; you can’t underestimate that. The great rise is equities is testimony to the growth in the global economy and growth in the global economy is growth in oil consumption.”