- A bearish week for energy
- Inventories weigh on the price
- Trade and the dollar have not helped
- The Middle East lurks in the background
- June is a crucial month- Volatility ahead
Thursday, May 23 turned out to be the worst day of 2019 for the oil market as the price plunged by 6%. The price of both WTI and Brent futures fell hard, and the technical breakdown has caused many trend-following traders to expect a deep correction, perhaps like the one we witnessed at the end of last year. The price of nearby NYMEX futures fell from $76.90 in early October to a low at $42.36 in late December as the price fell 44.9%. Over the same period, the price of the Brent benchmark futures declined from a high at $86.72 to $49.96 or 42.4%.
Past performance is never a guaranty of the future, but things were looking pretty ugly in the oil patch last Thursday as stocks also fell on the back of an escalation of the trade dispute between the US and China. With rhetoric flying between Washington and Beijing, the disagreement or skirmish as some politicians like to call it, is threatening to develop into a trade and a currency war which would threaten the global economy. Crude oil and stocks fell together during the final quarter of last year, and last week, they began to do a repeat performance.
A bearish week for energy
While many other commodities moved lower before crude oil on the back of the escalation of the trade dispute, the situation caught up with the energy commodity last week.
The daily chart of July NYMEX crude oil futures highlights the most substantial decline of 2019 on May 23 when the price fell below the $60 per barrel level. July futures settled at $58.63 on May 24. Both the price momentum and relative strength indicators crossed to the downside and are heading towards oversold territory. Daily historical volatility rose from under 16% to over 33% as the market took the elevator to the downside and did lots of technical damage to the bullish trend that had been in place since the late December 2018 low. The next level of support is at the $55 per barrel level, which could be in jeopardy.
The chart of active month July Brent futures shows that the price dropped below the $70 level on May 23, to a low at $67 per barrel. July Brent closed last Friday at $68.69. Brent is the benchmark pricing mechanism for around two-thirds of the world’s petroleum. Brent declined less than WTI during last week’s correction because of the situation in the Middle East, but its weakness is a sign of falling demand from China because of the ongoing trade dispute.
Inventories weigh on the price
One of the triggers for last week’s selling in the oil patch was the inventory numbers from the American Petroleum Institute and the Energy Information Administration. The API told markets that crude oil inventories rose by 2.4 million barrels for the week ending on May 17 last Tuesday, May 21. The market had expected a withdrawal of 2.53 million barrels, so the increase in stockpiles weighed on the price of oil. Additionally, the API said that gasoline stocks rose by 350,000 barrels while the market consensus expected a decline of 1.516 million barrels of the fuel. A drop of 240,000 barrels of distillates did little to support the market.
On Wednesday, May 22, the day before the price of oil experienced a significant decline; the EIA told the market that inventories increased by 4.7 million barrels which put total stocks at 4% above the five-year average as of May 17. Additionally, the EIA reported that daily output in the US reached a new record high at 12.2 million barrels per day. The EIA also said that gasoline and distillate stocks both rose by 3.7 million and 800,000 barrels respectively. While gasoline stocks are at the five-year average for this time of the year, distillate stocks are 4% below. The inventory data on Tuesday and Wednesday set the stage for the decline, but it was the trade dispute and the strong US dollar that pushed the price to the lowest level since March of this year.
On the other side of the fundamental equation for crude oil, Baker Hughes reported that the rig count dropped by five to 797 as of May 24. Compared to last year at this time, the number of rigs in operations was 62 lower which is not a bearish sign when it comes to production which could decline in the weeks ahead from the 12.2 million barrel per day level.
Trade and the dollar have not helped
On May 10, the US slapped 25% tariffs on Chinese exports to the US. On May 13, China retaliated with protectionist measures on US exports. At the same time, China continues to devalue its currency, the yuan, to stimulate the economy. The weaker yuan makes the US dollar stronger and pushes the two nations closer to an all-out trade and currency war.
China is the demand side of the fundamental equation for most commodities, and crude oil is no exception. While copper and other raw material prices fell before the price of oil, the energy commodity caught up last week. The inverse relationship between the US dollar and commodities prices is also weighing on the asset class. The dollar is the world’s reserve currency, and a higher dollar is typically bearish for the prices of commodities.
As the weekly chart shows, the dollar index rose to a new and higher high at 98.26 on May 23, the day that crude oil experienced its most substantial decline of 2019.
The Middle East lurks in the background
The technical and fundamental picture for crude oil looks pretty ugly as we head into June. The path of least resistance for the price of oil is now lower, and it seems a lot like it did back in October when it was heading for an almost 45% decline. However, the situation in the Middle East is a reminder that the supply landscape can change in the blink of an eye. After the US refused to extend exemptions on eight countries purchasing crude oil from Iran, including China, in April, the rhetoric between Teheran and Washington has increased.
In 2018, Iran warned the US that if they are cannot sell their oil to customers around the world; they will prevent other exporting nations in the region from shipping their crude oil. The Strait of Hormuz is a narrow passageway that separated the Persian Gulf from the Gulf of Oman. 20% of the seaborne crude oil heading to consumers around the globe travels through the Strait each day. The Strait has become a political chokepoint for the energy commodity as it borders on Iran. Over the recent weeks, sabotage against a handful of oil tankers off the coast of the UAE and a done attack on a Saudi pipeline near Riyadh are signs of Iran’s intention to follow through on its threat. The US dispatched the USS Abraham Lincoln warship to the area as the political temperature in the region continues to rise. While last week’s action in the crude oil market was bearish, any attacks or hostilities that threaten or damage production, refining, or logistical routes in the world’s most turbulent political region could cause price spikes to the upside in the oil futures market.
The chart of the price of WTI minus Brent crude shows that the spread between the two benchmarks has risen to $10.22 per barrel at the end of last week. The high in the spread dating back to 2015 was at $11.55 in May 2018, and it is heading for that level. While rising US production and inventories and OPEC production cuts are pushing the spread higher, it also serves as a barometer for political risk in the Middle East, which is rising. The threat of supply disruption is a reason why the premium for Brent is rising. Since the Arab Spring in 2010, a rising Brent premium compared to WTI is typically a bullish sign for the price of crude oil.
Therefore, a continuation of the bearish trend that started in April is far from a certainty in the current geopolitical environment. Instead, the oil market has the potential for wide price variance over the coming weeks and perhaps months.
June is a crucial month- Volatility ahead
June will be a critical month for oil and markets across all asset classes. We will have to wait until the end of the month as the OPEC meeting is on June 25 and 26 in Vienna, Austria. The oil ministers of the cartel will gather on June 25 and given that arch-enemies Iran and Saudi Arabia will be in the same room, it is likely that nothing will be accomplished when it comes to production policy for the second half of 2019. However, on June 26, Russia will meet with the cartel members, and while Russian oil minister Alexander Novak and President Vladimir Putin are not official members, they have dominated OPEC policy since 2016 when the price of nearby futures on NYMEX fell to a low at $26.05 per barrel. The decision on if the cartel will continue to keep quotas at the level from last year which put a 1.2 million barrel per day cut in place will rely on Russian cooperation. The recent drop in the price of the energy commodity makes it more likely that the production cut will remain for the rest of 2019.
The oil futures market is likely to experience increased volatility as the meeting approaches and in its aftermath.
Once OPEC is out of the way for the oil market, Presidents Trump and Xi will meet in Osaka, Japan, on June 28-29 to discuss the escalation of the trade dispute. If the two leaders can agree to continue negotiations and make progress, it would likely turn the current pessimism back into the optimism over the prospects for a trade deal. However, if the summit goes the way of President Trump’s meeting with North Korean leader Kim Jong Un, fear and uncertainty over the future of the global economy could send markets into a tailspin.
We should expect lots of volatility in markets across all asset classes in June. While I still expect that the US and China will agree on terms for trade because of economic reasons for China and political factors for President Trump, anything is possible. When it comes to crude oil, trading rather than investing is likely to be the best approach to the market. Buying dips when crude oil looks awful and selling rallies when it seems like it is moving back to the highs with tight stops is likely to be the optimal strategy. For those who do not trade in the highly-leveraged and volatile futures market on NYMEX, the UCO and SCO double leveraged long, and short products provide an alternative.
The carnage in crude oil over the past week changed the technical path of the market. Meanwhile, with Iran lurking in the background, it is not a no-brainer that the energy commodity will follow the same path it did during the final quarter of last year.