Drilling Down on Oil
12/24/2012 7:00 am EST
Continued sluggishness in global economic conditions and weak oil demand have been the main drivers of oil prices in recent months. The staff of EconMatters offers their technical and fundamental outlook.
When discussing this analysis we shall focus on WTI (West Texas Intermediate) crude oil—the oil markets trade together for all intents and purposes, but often Brent crude oil trades $20 higher, give or take $3, depending upon certain European and Middle East news, and contract rollover repositioning (i.e., Brent contract rolls before WTI).
King of Day Trading
Brent has gained importance, and is used much more for benchmark due to the fact that it better represents global prices, and most refiners sell their end products based upon the Brent contact. However, WTI is still the undisputed King of Day Trading, and has the dedicated Pit presence in New York, which runs from 8:00 am to 1:30 pm CST, and ultimately is still where all the consistent, major price discovery takes place. Or to say it non-euphemistically, the Pit is where all the action is! So WTI is still by volume the most widely traded crude oil contract in the world on a consistent basis, and we will base our technical analysis on the WTI CL futures contract for options trading.
WTI has traded in a largely rangebound manner for the last two months with the bulk between $85 on the downside and $89 on the upside, a very tight $4-dollar range. We have had push downs intra-day all the way to just below $84, and push-up moves just above $90. Nevertheless, price didn’t stay there long as buyers and sellers jumped all over those price levels, and made money as price moved back to the meat of the trading range, which is where we currently find CL at approximately $86 a barrel after the first week of December.
2 Month Crude Oil Chart
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Expect a push-up with all other risk assets if we get some semblance of a fiscal cliff deal or expect a push- down if we fall off the cliff. Depending upon the makeup of the fiscal cliff deal, i.e., the grand design, or just kicking the can down the road with a minimalist measure, there will be some type of rally in crude oil.
Crude oil (USO), unlike equities, will still have to account for the fundamentals which have been bearish, and could temper any rally from developing into a sustained trend. For example, even though crude oil is being purged for tax purposes and refineries are running at a 90% run rate, it is barely making a dent in crude oil supplies, and the end products are starting to build inventories because the demand for end products just isn’t strong enough right now.
Rising petroleum end product inventories means less need for oil in the future. I expect products to build with slight draws in crude oil through the end of the year. If we get builds in both crude oil stocks and end product stocks (XLE) (OIH), it will put downward pressure on oil, and we will test the $84 level to validate whether that level holds through the remainder of this year.
Oil trades like an asset class similarly to equities (SPY) or gold (GLD). If we have an event where major selling occurs in all asset classes, this is the most likely scenario for buyers stepping away from the $84 level, and letting WTI fall to the next level of support at around the $80 level, with the next support at $78 a barrel. These are the near-term levels of support that have always supported the contract, and where buyers have stepped in after major push downs, usually liquidation events are responsible for reaching the $78 level. Then buyers step in, the shorts cover and price moves rather quickly to the $83 level.
The first quarter of every year is where fund managers make their numbers, so new money usually flows into asset classes during the first of the year. Under that scenario, WTI should move up and test the upper part of the range and whether it can push through the $90 level will depend on whether inventories can come down, i.e., several weeks of drawdowns leading to months where we take 10 to 12 million barrels off the existing inventory levels in the 370 million area currently. We need to see at least 30 million barrels of drawdowns to move price back to the $95 a barrel level. Without this, any rallies in WTI will be faded or sold into curtailing any sustained momentum from forming.
6-Month Crude Oil Chart
So oil for the next three months will be more of a trader’s market and less of a trending market where traders have to take pieces of prices where they can, and avoid buying or selling the top and bottom of the market unless extreme circumstances present themselves. The trader can buy small technical price breakouts, but always be wary of being too committed to these breakouts, as we have seen by the last two months price quickly reverts back to the bulk of the trading range.
The successful CL trader will be nimble, watch their technical levels, and get in and out for the most part, with occasional mini trends to take advantage of from time to time. With abundant supply levels, volatility is definitely on the decline. Most of the volatility will probably stem from asset rebalancing, market dislocations in one asset class affecting other asset classes, and I expect more volatility to the downside than upside.
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Real Down-Side Pain
The stronger case for real pain, i.e., participants stepping away from the market or being surprised by the market, is to the down side, in my opinion. This could occur because of a major down grade of US debt, over supply issues, or Europe sinking further into recession than forecast.
Any break and close below the $78 level pushing down to the next level of support would cause major pain in the oil market, as many models would be violated by this occurrence.
1-Year Crude Oil Chart
Once models are violated, all bets are off when it comes to commodities, and price seemingly goes farther than one would logically predict, i.e., it is too low to be going down further. This phenomenon causes buyers to step in trying to catch a falling knife, and their getting stopped out adds additional fuel to the downside move. If everybody believes that $75 should hold, and it doesn’t, panic ensues from real pain in the market, buyers step away altogether, and price can go farther than you think to the downside.
Market Feel & Technical Analysis
WTI is a commodity, and commodities adhere more to technical analysis criterion than other asset classes, but technical analysis is not perfect or something that can be applied rigidly or religiously. It is just a tool to be used as a guide with other sources of information like fundamentals, market sentiment and mechanics, economic reports, consumer and investor trends, capital flows, geo-politics, OPEC decisions, maintenance and outages, natural disasters, and other inputs to the oil equation.
But most of all, technical analysis revolves around market feel for how to apply technical analysis, when it will be violated, when it is likely to hold, close enough levels, etc. This ‘market feel’ is the most difficult skill to acquire in the quest of mastering oil markets.
A successful oil trader has to have a great feel for what the market is currently doing, and this serves as a solid base for what the market is likely to do next for options trading. The “feel” for how to apply technical analysis is the ‘art’ in the equation that overlays the ‘science’ of historical pricing patterns.
By the Staff of EconMatters