Crude Oil has reluctantly played follow the leader with U.S. equities for much of the past 12 months. More recently, fundamentals took a back seat to short term speculation as risk takers drove the price of hot button commodities up with stocks. Crude has been in a holding range between $80 and $87/barrel for all of March and April, but in the past two trading sessions NYMEX WTI crude plunged directly from the top to the bottom of that range.
Factors Affecting WTI Spots
The BP Gulf spill, gasoline demand reaching 3.5% yoy, prices at the pump at $3.00, refinery capacity above 89%, Cushing, OK crude storage dwindling to 14 million barrels, tankers holding countless barrels off the coast, OPEC members breaking quota, unrest in Iran, and sovereign default contagion in Europe have been on the radar of "black gold" speculators for the past two months. These realities are the extension of maturing trends over the range bound past two months, but only one has significantly altered WTI Crude prices. A casual deduction might blame oil's price destruction on a stronger Dollar, due to the recent flight from all things Euro. Contrarily, we see default risks in the EU and retrenching speculation creating the vacuum through which industrial commodity prices, most notably Oil, will fall.
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In January we correctly called a bearish trend reversal in Crude Oil prices and predicted the fall to $70 / barrel. Our prediction seemed far fetched at the time, while Crude was trading near $80, but we were right then in identifying the speculative forces surrounding crude oil. Now discounting for newly developed sovereign default risks in the EU and the effects of a plummeting Euro on the price of all industrial commodities, we foresee a very similar reversal the second time around.
The MACD peaks have continued along the negative sloping trend line, congruent with a bearish wedge reversal, while recent events regarding the Greece bailout have had direct impacts on the price of the WTI continuous Crude Oil spot price. In April, the WTI spot reached the $87 mark in intra-day trading three times, but each time closed lower and weaker than the last. The Relative Strength Index (RSI) now reads below the neutral 50 mark, suggesting that momentum has reversed and bearish sentiment is now leading prices.
Wedensday, April 28 through Friday, April 30, Crude Oil climbed near its yearly high of $87 on rumors that led to PM Papandreou accepting a 110 billion Euro bailout from the EU on Monday, May 3. On Monday, the price of crude again reached its $87 high intra-day, before closing just above $86.
Greek Bond Spreads to German Bunds, 2yr & 10yr Maturities (April 22, 2010)
So why did crude oil sell off in the wake of this "stability" in the EU? We would argue that the situation surrounding the Greek debt crisis is now anything from stable, and has in fact grown to an unstable monster that could drown much more than just Oil and EU stocks. We don't claim to have any inside edge on the contagion risks of defaults in the EU, but we do trust a certain Mohamad El-Erian, of PIMCO's total return bond fund, the largest bond fund in the world. El-Erian appropriately warns, "it is far from assured that this program will forcefully counter contagion risk," as seen in the recent chart, compliments of Business Insider. In the time since this chart was built Greek yields have rocketed even higher, where on May 5, 2010, Greek 10 yr spreads over German Bunds rose to above 700 bps, putting the headline yield on Greek 10 yr bonds above 10.5%.
Austerity measures in the form of pension reductions, bonus cancellations, and job cuts are planned to cut Greece's budget by 13 billion Euros, in exchange for EU loans at 5%. Naturally, markets don't like the deal, since the EU is absolving Greece's bad debt at a loss, where the interest on the loan to Greece is half that of the market yield for 10 yr debts.
So how are the Greeks taking the medicine? We'll let you judge for yourself in this week's DS Video, compliments of CNBC, covering the the budget cut protests.
The Future of Crude
At this point it isn't crucial that the EU break up for Crude Oil to fall to $70 or below. 2010 gasoline demand is trending towards 3.5% as prices at the pump average above $3/gallon in the U.S., but leading indicators seem to be topping, as the ISM non-manufacturing new orders component trended lower and retail sales are narrowing closer to 2% yoy for April. The past 12 months have been an atmosphere of loose money and speculation, while globally, growth has recovered due to stimulus packages and corporate spending supported by higher equity valuations. All in all, we see global energy demand near its peak, given (Quantitative Easing) QE cooling in China and European weakness due to eurozone cost cutting.
Our analysis supports the position that Crude Oil spot prices still reflect a great deal of recovery linked to speculative forces. Further, moderate gains in demand for crude and distillates are countered by the bulging supply of U.S. inventory and OPEC member countries producing above quotas, partially to fund stimuli plans and state bailouts of their own (e.g. Dubai World).
The only recent game changer for Crude Oil has been Greece and the ensuing sovereign default contagion risk. We are playing this risk using crude oil, because the volatility allows for large price swings to capture gains with positive correlation to the situation in Europe. Finally, the ceiling for WTI spot prices is a firm resistance level ($87), and therefore much safer than the erratic behavior of direct EU crisis plays (e.g. Greece, Spain, Portugal Bonds, the Euro, Euro Equities, etc.).
Specifically, we like DTO (Powershares DB Double Short Crude Oil ETN), since it's generally liquid enough for our taste (500k-1 million volume/day), and tracks -2x the WTI Crude Continuous Spot.
Disclosure: Long DTO over the next 2-4 weeks