Crude Oil- Pulled In Opposite Directions

• Range trading in the oil futures market
• Recession is bearish for crude oil- the forward curve offers some clues
• Crack spread reflect seasonal factors, but they are weak
• Iran remains bullish
• Bargains galore in oil equities- What is cheap will likely get cheaper

The market structure of any commodity market consists of term structure or the forward curve, location and quality spreads, substitution spreads, and processing spreads. Together these factors often yield significant clues about the path of least resistance of the energy commodity.

Meanwhile, the current state of the crude oil market is confusing. The Middle East has the potential to cause price spikes to the upside in the blink of an eye. On the other hand, a global recession could cause the price to take the elevator to the downside as we witnessed in 2008 during the global financial crisis.

One of the most concerning factors has been the performance of crude oil-related equities. Some of the companies in the oil patch have moved to lower levels than when the price of oil was substantially lower. The bottom line is that bullish and bearish factors are pulling crude oil in opposite directions these days, and the market is waiting for the next shoe to drop. 

Range trading in the oil futures market

In 2019, the price of nearby NYMEX crude oil futures traded between $44.35 and $66.60 per barrel. The low for the year came at the very start, and the high in late April. The trading range of $22.25 in 2019 compared to a band of $34.54 in 2018. In 2017, the range was $18.46, and in 2016 it was $28.46. The last time crude oil hit the $100 per barrel level was in 2014, and it has been below $77 since then. Crude oil has not traded below the $42 per barrel level since August 2016, three years ago.

Since late April of this year, the trading range narrowed in the crude oil market.

Source: CQG

Since the week of April 22, the price has traded from $50.52 to $66.60 per barrel or $16.08. The trend in the oil market over the past four months is lower as the energy commodity has made a series of lower highs. However, the bottom end of the range and technical line on the downside is at $50 per barrel. A move below there could cause trend-following selling to intensify. When it comes to technical metrics, price momentum and relative strength indicators are below neutral, but above oversold territory. Open interest, or the total number of open long and short positions in the crude oil futures market, has been edging lower and was at just under two million contracts at the end of last week.

Bullish and bearish factors are pulling the price of crude oil in opposite directions. At the end of last week, another in a long series of escalations in the trade war between the US and China pushed the price of crude oil lower.

Recession is bearish for crude oil- the forward curve offers some clues

The crude oil market does not do well during risk-off periods, financial crisis, and downturns in the global economy. The last significant recession occurred during the global financial crisis in 2008.

Source: CQG

As the chart shows, in July 2008, the price of NYMEX crude oil futures reached an all-time high at $147.27 per barrel. Over the next five months, the price dropped to a low at $32.48 or 77.9%. In another example of how global economic weakness weighs on the price of crude oil, in early 2016, the slowdown in the Chinese economy took the price to a low at $26.05 per barrel.

Meanwhile, the forward curve in the crude oil market can provide clues when it comes to the fundamental supply and demand equation for the energy commodity at times. Backwardation is a condition where deferred futures trade at lower levels than nearby futures and is a sign of supply tightness. Contango occurs when deferred prices are higher than nearby prices and usually occurs in markets that are in equilibrium for where supplies are higher than demand.

Source: CQG

The chart of the price of December 2020 minus December 2019 NYMEX crude oil futures shows that the forward curve was in a backwardation of $2.54 per barrel as of August 23. The backwardation declined from a high at $4.69 in late April when the price of oil was on the highs. However, it was at a lower level than in mid-June when the spread traded to a $0.70 backwardation when the price of oil was close to the low end of the trading range.

The same spread in Brent futures settled at a $1.93 per barrel backwardation on August 23 as the forward curve in WTI was slightly tighter than in the Brent futures. The forward curves are not flashing any significant signals at the current levels. However, since both are in backwardation, they do indicate some degree of perception of tight supplies in the contracts for nearby delivery.  

If the current concerns that a recession is on the horizon turned out to be accurate, the oil market could be in for an elevator ride to the downside when the energy commodity falls through the $50 per barrel level.

Crack spread reflect seasonal factors, but they are weak

Crack spreads are the economics of processing a barrel of crude oil into oil products, or gasoline and distillates. Nearby crude oil futures settled at around the $54 per barrel level at the end of last week. Last year at the same time, they were trading at the $68.50 level.

Source: CQG

The chart shows that the gasoline refining spread closed last week at $10.07 per barrel, compared to $14.31 per barrel at the same time in 2018. With both the price and refining spread lower this year, the crack spread is telling us that supplies are greater than demand in the gasoline market.

Heating oil is a distillate fuel, and the futures contract often serves as a proxy for other distillates like jet and diesel fuels.

Source: CQG

At $22.49 per barrel, the distillate crack spread was lower than last year at the same time as it was at the $24.06 level in late August 2018.  

The processing spreads are sending bearish signals for the crude oil market at the end of August as demand for products translates to demand for the raw energy commodity. Lower crack spreads in an environment where the price is lower than last year is not a fundamental bullish factor for the price of the energy commodity.  

Iran remains bullish

The complex jigsaw puzzle that determines the path of least resistance for the price of oil must include the geopolitical risk of the commodity. These days, that risk comes down to four letters—Iran.

US sanctions are choking the Iranian economy. The hostile rhetoric continues to fly back and forth between Washington and Teheran. President Trump walked away from the 2015 nuclear nonproliferation agreement in 2018. The President put sanctions on Iran, and after allowing eight countries to purchase crude oil from the theocracy from November 2018 through April 2019, did not renew the exemptions.

The economic sanctions have been a noose around the neck of the Iranian leadership. After more than a few retaliatory incidents, things have been quiet over recent weeks. However, with the US military presence in the region, that could change in the blink of an eye. Any incidents or hostilities that impact production, refining or logistical routes for crude oil in the Middle East could cause a sudden price spike to the upside. The region is the home to 50% of the world’s crude oil reserves, and nothing would spark a short-term rally like supply concerns.

Bargains galore in oil equities- What is cheap will likely get cheaper

At the end of last week, the pressure on the crude oil market was growing, and a test of $50 or lower could be in the cards for the energy commodity. However, Iran could be the one factor that underpins the price at this time.

Meanwhile, selling in stocks and crude oil could send oil-related equities even lower over the coming weeks. The share prices of many of the companies in the sector are already weak.

Source: Barchart

At $55.96 last Friday, the S&P 500 Energy SDPR (XLE) was not far above the late 2018 low at $53.36 per share. The price of crude oil was over $11 higher than the December 2018 low, but the shares were much closer. The next level in the XLE to watch is at the 2016 low at $49.93 if the weakness in the stock market persists.

One sector of the oil market has already declined below all support levels. The shares of oil services companies have been the Rodney Dangerfield of the industry as they have received absolutely no respect.

Source: Barchart

At under the $11 level, the VanEck Oil Services ETF product has already taken out its lows from late 2018 and all prior years. It recently fell to a low at $10.76 and was not far off that level at the end of last week. Oil services shares have even underperformed the rest of the weak sector. OIH holds the leading companies in oil services including:

Source: Yahoo Finance

The ETF charges an expense ratio of 0.35%. The companies deliver a blended dividend yield of 2.07% at the current share prices, which more than pays the expense of the product.

The oil market looks like the price of the energy commodity is heading lower, but it is not all that simple from a fundamental standpoint. Recession is bearish, but Iran is bullish. The news cycle could cause lots of volatility in the world’s most ubiquitous energy commodity before it decides on a price direction.