How Long Can Crude's Disconnect To Risk Assets Continue?

 |  Includes: OIL, USO
by: Ananthan Thangavel

Crude oil has recently disconnected from the rest of the risk asset complex, continuing to rise another 8% after October 27, even after the euro, Australian dollar, and equities all peaked. Contributing greatly to crude oil's rise was the rumor and eventual news of the reversal of the Seaway pipeline, opening a direct line of transport between Cushing, OK., and the Gulf of Mexico.

Such a development is important fundamentally because accelerating oil production in the Bakken shale in North Dakota, as well as Canadian production was becoming bottlenecked in Oklahoma, causing WTI prices to come under pressure even as Brent crude prices stayed fairly stable. This phenomenon caused WTI crude to trade at a record $27 discount to Brent on October 14. Since then, the spread has narrowed all the way to $10, hitting a low of $9.29 on Wednesday.

While the Seaway pipeline should help alleviate the inventory buildup in Cushing, WTI's rise over the past month can largely be attributed to the breakdown of the spread rather than favorable demand dynamics. From its October 4 trough to today, WTI is up 30%. In the same time span, Brent crude rose only 8%. Considering Brent's much wider use (Brent is used by China, Europe, etc.) Brent prices are a much better gauge of crude demand than WTI. Indeed, RBOB gasoline was actually down 0.5% in the same time span, indicating that increased gasoline demand did not accompany crude's rise. It appears that WTI's rise is primarily being caused by a massive unwind of the long Brent, short WTI trade, as well as a generally increased long posture by Managed Money.

The following charts show the price of WTI against Managed Money longs, as well as the gross Managed Money short position.

charts courtesy of 11/21 Commodity Analyst Newsletter

As can be seen, crude Managed Money net longs remain at an elevated position, but most striking is the collapse in Managed Money shorts. Managed Money shorts reduced their position to the lowest since May 17. This short covering certainly contributed to crude's incredible recent rise, but given the deteriorating macroeconomic environment, we believe crude shorts could shoot right back up.

Further lending credence to the view that energy demand remains weak is a comparison of WTI crude and RBOB gasoline prices.

As can be seen, while WTI and RBOB usually move in lockstep, the performance of the past month has been an anomaly. RBOB has shown weakness while WTI has been on a march straight upward. While this could theoretically give way to both rising together, we believe the larger macroeconomic picture favors the downside. With US consumers stretched, deleveraging, and completely devoid of confidence, further price increases will destroy demand for energy, a fact reflected in RBOB's continual downward trend. We expect WTI to reverse course presently and follow RBOB downward.

Trade Recommendation

Given its stretched Managed Money long positions and the general negative macro environment, we view WTI crude as an ideal short. As stated above, we recommend shorting WTI crude at a price of $97.67 or better. To contain risk, investors could place a stop-loss order slightly above the 61.8% Fibonacci retracement level of $99.60, with the Fibonacci retracement drawn from the April 29 high to the October 4 low.

Disclosure: Short WTI crude futures

Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.