An Oily Situation For Risk Assets

Includes: OIL
by: Seven's Report

The action in oil of late has been very bearish, with the price of WTI Crude Oil collapsing below the lows of the prior two weeks. The selling in the oil patch strongly suggests that the correction/decline we've seen in the price of "the lifeblood of modern society" isn't over yet.

Interestingly, the big drop in price on October 3, came on a day when the weekly inventory numbers were actually bullish. Here we saw crude oil inventories fall by 482,000 barrels vs. an expectation of a 1.5 million barrel increase.

Explanations for the decline in inventory focused on a lack of demand for energy due to the sluggish economy, and I'm sure that has something to do with it. However, I don't think that explains why crude oil has fallen so much during the past month. One reason I say that is because the economy hasn't really deteriorated that much over the past month, and consumer spending hasn't collapsed, nor have incomes. Another more important reason, however, is the fact that the price spread between the first two contract months in crude is basically unchanged.

As a former floor trader for Merrill Lynch, I learned that one key to determining whether a move in crude (and other commodities) is supply/demand based is to watch the spread between the first two contract months.

If a decline in crude is truly because the supply/demand picture is getting more bearish, you'll see that spread widen as near-term demand slackens and affects the current month more so than the months further out. Think of it like a snake, where the head turns first, and then the rest of the body follows.

But this "serpent effect" hasn't taken place in crude.

In fact, the spread (known as contango because the second month is priced higher than the front month) between front month contract and the second month in WTI Crude was 30 cents on September 14, right before the market broke, and at the close of trading on October 3, it was 40 cents, or basically the same.

This tells me that it isn't a supply/demand function that's crushing the crude market, and that makes me nervous about what it means for risk assets. In fact, I keep looking back at May, when crude oil prices broke a few weeks before the market, and it happened again to a much lesser extent just last month.

I'm concerned that this leg lower in oil might be a precursor to a wider decline in risk assets such as equities. I'm going to keep an eye on support at the $97.58 level here for signs of a breakdown. If that level fails to hold, that's a hugely bearish signal for energy in general-and quite possibly for stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.