In a recent article I laid out the case for crude oil trading below $60 in the near future. Equity weakness over the past week shows that the journey to lower crude oil prices has now begun. It seems that neither the supply/demand picture for crude oil itself nor OPEC quotas are having the effect that many believe.
The fact of the matter is that crude oil has been tracking very closely with equities for the last two years and is being controlled only by traders and investors seeking risk, most likely fueled by the cheap dollars of the carry trade. Notice in the chart below how crude oil has tracked very closely with the S&P 500 since August 2008.
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Next lets have a look at the economic outlook poster child, the copper market. The same high correlation exists, except on this chart, notice the ominous head and shoulders pattern that copper and crude oil are forming. The same head and shoulders pattern is forming in equities as well which proves that all of these markets are connected and move in tandem. Granted, these patterns take time to develop, but if crude breaks below $70, that forecasts a downside target of $53.
Next let's take a look once again at the divergence I pointed out in a recent article between the ten year note yield and the S&P 500, only this time let's compare the ten year yield to the price of crude oil. Crude oil is an obvious risk trade which means that when the price of riskier assets are rising, interest rates should be as well as money flows from safer investments (treasuries) into riskier asset classes. Notice how the ten year yield and the price of crude have tended to peak and trough around the same time until recently when ten year yields have tumbled, signaling that the risk trade necessary to support crude oil prices is being unwound.
Finally let's take a look at the crude oil market itself. The chart below of the continuous crude oil futures contract shows two main pieces of evidence that crude oil traders are not willing to support prices at current levels which will provide further fuel for a decline. Notice first how open interest has been steadily declining as the price of crude oil has advanced off of its May 20 low. Open interest is the number of 'open' contracts being held by traders. If it rises with prices, it confirms that new traders are taking positions, thus lending support to rallies. If prices advance and open interest declines, that shows that traders are leaving the crude oil market. That is evidence that the recent rally was short covering and not much else.
Next, take a look at volume. Volume is the life blood of any rally. Volume patterns do not need to be overwhelmingly positive to support rallies, they only need to be consistent, showing that buyers and sellers are in reasonable agreement that the best value of whatever is being traded sits at a higher level. When volume is in an obvious decline as prices advance, however, that is a sign once again that the necessary support structure for higher prices is absent, thus opening the door for sellers to take control. Also notice how volume has picked up as price has come off of its recent high. This shows that sellers are dictating the price action.
Crude oil's inability to trade on its own merits has no doubt helped sustain its higher price level. Crude's high correlation with equities and mounting evidence that equities have begun a new leg down does not bode well or crude oil as risk trades are being unwound. Am I saying that crude oil will never reach $100? No, I'm not. One thing is certain, however, crude will break below $60 first.
Disclosure: Author is short crude oil.
Disclosure: Short Crude Oil