A Crude Oil Rally Above $40 A Barrel Is Unsustainable As The U.S. Economy Falters

Summary

• A crude oil rally above the $40 per barrel level is unsustainable in light of decelerating U.S. and global economic growth.
• Crude prices previously showed a direct correlation with the 10Y/2Y yield spread, but began to decouple on speculation of an OPEC deal.
• Unless crude prices stay decoupled from the yield spread, the price of crude oil is at risk of pulling back.
• The XLE ETF could pull back to the $56.31 per share support level, if the WTI crude price falls.

The price of crude oil has been on a sharp rebound since plunging to the February 11th low of $26.05 per barrel, or the "Janet Yellen low", when Federal Reserve Chair Janet Yellen told the U.S. Congress on the second day of her two-day semiannual monetary policy report that overseas weakness and market distress could threaten the Fed's plans to raise the rate, but didn't explicitly mention any delays to interest rate hikes. The crude oil price now bumps into major head resistances, where the breakout point of the long-term downtrend is about $40 per barrel. In our viewpoint, a crude oil rally above this level is unsustainable in light of decelerating U.S. and global economic growth.

Oil Prices to Stay Low - Jeffrey Currie, Goldman Sachs' head of commodities research, issued a report on Tuesday saying that the recent rally in commodities is just a "mirage", "premature" and "not sustainable," according to MarketWatch. As Mr. Currie put it in his report,

Energy needs lower prices to maintain financial stress to finish the rebalancing process; otherwise, an oil price rally will prove self-defeating as it did last spring,

A dark cloud over the U.S. and global economies is on the horizon, as the China economic slowdown continues and some hawkish Fed members seem to be maintaining their plans for aggressive rate hikes. According to Bloomberg, Willem Buiter, Chief Economist at Citigroup, sent out a note to their clients late last month to get ready for a global recession.

The most recent deterioration in the global outlook is due to a moderate worsening in the prospects for the advanced economies, a large increase in the uncertainty about the advanced economies' outlook (notably for the U.S.) and a tightening in financial conditions everywhere," said Buiter in his note.

Lower demand for crude oil during the next few years prompted the U.S. Energy Information Administration, or EIA, on Tuesday to trim 2016 U.S. oil demand growth by 80,000 barrels per day, or bpd, from 110,000 bpd, and cut its 2016 worldwide demand growth forecast by 90,000 bpd to 1.15 million bpd. The EIA now expects WTI crude oil prices to average $34.04 a barrel in 2016, and $40.09 a barrel in 2017.

Faltering U.S. Economy - There are warning signs that something is wrong with the U.S. service sector, accounting for nearly 80% of the private sector gross domestic product, or GDP. A preliminary reading of the Markit Economics monthly flash services purchasing manager's index, or PMI, for February, came in at 49.8, missing the estimate of 53.5 by a wide margin. A reading below 50 means the service sector of the U.S. economy is in contraction.

The recent report, "Faltering U.S. Economy Leads Global Slowdown" by Chris Williamson, Chief Economist at Markit, states that,

Global economic growth slowed to near-stagnation in February, according to PMI data. … Weakness was broad-based across both the developed and emerging markets. … U.S. PMI series for both manufacturing and services fell sharply again in February. Bad weather was partly to blame, but weaker underlying demand meant February was the second-worst month since the global financial crisis.

The Institute for Supply Management, or ISM, said in early March that its index of non-manufacturing activity fell to 53.4% in February, from 53.5% the previous month. The figure, which was barely above expectations of 53.2% from a Reuters poll of 81 economists, corresponds to a 1.8% increase in real gross GDP on an annualized basis, according to the ISM. A reading above 50% indicates the non-manufacturing sector economy is generally expanding. The ISM index has been on a downtrend since July 2015, when the reading was 59.6%.

Despite that the U.S. labor market continues to strengthen, wages remain stagnant. The Labor Department said last week that there were 242,000 nonfarm payrolls jobs added in February, exceeding Wall Street economists' forecast for a 190,000 job gain. The vast majority of jobs, about 150,000 however, came from healthcare, social assistance, retail, and food services, meaning low wages. This could explain why average hourly wages declined 3 cents to $25.35, following an increase of 12 cents in January.

The chart pattern of the yield spread between the 10-year and 2-year Treasury Notes is starting to break down, after the yield spread dipped below the key technical support at 0.99 percentage point in late February for the first time in 8-years. The yield spread, at 0.95 percentage point on Tuesday, was the lowest level seen since late 2007. The next key technical support is at 0.86 percentage point, if the spreads continue to fall. Falling spreads may indicate worsening economic conditions in the future, resulting in a flattening yield curve. A very low or negative spread could signal an upcoming recession. Since 1960, each time that the yield spread went negative, a recession followed approximately 12-months later.

Yield Spread and Crude Oil - There is no simple explanation for how crude oil prices, the U.S. dollar, and the bond yields are correlated. The general consensus is that crude oil prices move in inverse correlation with the U.S. dollar, meaning the crude oil prices would fall as the dollar strengthens, and vice versa.

According to Business Insider, a 2014 report by Goldman Sachs' Jeffrey Currie shows that such rationale has broken down in the wake of the American shale revolution. Currie explained that the U.S. net imports of crude oil have reduced significantly since 2008, as U.S. shale production has surged. This has "significantly reduced the correlation between commodities and the U.S. dollar," said Currie in his report.

Since early 2014, the WTI crude price has shown a direct correlation with the yield spread between the 10-year and 2-year U.S. Treasury Notes, meaning the crude oil prices have been falling as the yield spread narrows. A simple explanation would be that investors have backed off risky assets, including equities and commodities, on fears of a looming economic slowdown, sending yield spreads lower. As the 10-year and 2-year yield spread moves lower, the downward pressure on crude prices increases.

The price of crude started to decouple from the 10-year and 2-year U.S. Treasury Notes yield spread following a February report that Saudi Arabia and Russia ministers agreed on an oil production freeze at the January levels, if they are joined by other large producers. Qatar, Kuwait and Venezuela said later that they would join the production freeze. The yield spread between the 10-year and 2-year U.S. Treasury Notes continues to narrow, as some on Wall Street are thinking that the Fed will keep hiking interest rates until the U.S. and global economies fall into recession. As speculative buys of crude oil continue, crude prices and the yield spread could stay decoupled.

Crude Oil and Related ETF Technical Outlooks - The WTI crude oil price is on the rebound as speculations that the Organization of the Petroleum Exporting Countries (OPEC) was going to strike a deal over production. The crude oil price is now bumping into major head resistances between $37.75 and $40 per barrel. A breakout rally above $40 per barrel is very unlikely and unsustainable if the U.S. and global economies continue to decelerate. Unless crude prices stay decoupled from the yield spread between the 10-year and 2-year Treasury Notes, the price of crude oil is at risk of pulling back near-term, to support levels at $34.82 and $32 per barrel.

Two popular exchange traded funds, or ETFs, United States Oil Fund LP (NYSEARCA:USO) and the Energy Select Sector SPDR ETF (NYSEARCA:XLE), are traded in direct correlation with the WTI crude oil price. USO tracks the daily price movements of the WTI crude oil price and shows a strong positive correlation (+0.97) with WTI crude oil over a 16-month period.

The XLE ETF, which tracks the S&P 500 Energy Select Sector Index (NYSE:IXE), holds three big cap oil, gas and energy equipment and services companies, Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and Schlumberger (NYSE:SLB), with about 42.98% of the holdings and a combined market cap of over $614 billion, as of March 10. The ETF shows a strong positive correlation (+0.93) with WTI crude oil over a 16-month period. The XLE could pull back to the $56.31 per share support level, if the WTI crude price falls back to a range between $34.82 and $32 per barrel.

Conclusions - The price of crude oil has been on a sharp rebound since plunging to the February 11th low of $26.05 per barrel. The crude oil price now bumps into major head resistances, where the breakout point is $40 per barrel.

Lower demand for crude oil prompted the EIA to trim its forecasts for 2016 U.S. and worldwide oil demand. A dark cloud over the U.S. and global economies is on the horizon with China's economic slowdown continuing and the service sector of the U.S. economy in contraction, as seen by the Markit flash services PMI, and the ISM non-manufacturing index on a downtrend since July 2015.

Since early 2014, the WTI crude price has shown a direct correlation with the yield spread between the 10-year and 2-year U.S. Treasury Notes, meaning the crude oil prices have been falling as the yield spread narrows. The yield spread, recently at 0.95 percentage point, was the lowest level seen since late 2007. The price of crude started to decouple from the yield spread in February on speculation that OPEC was going to strike a deal over production, but unless crude prices stay decoupled from the yield spread, the price of crude oil is at risk of pulling back, thus affecting oil-related ETFs, such as USO and XLE.

In our viewpoint, a crude oil rally above the $40 per barrel level is unsustainable in light of oversupply and decelerating U.S. and global economic growth.

Disclosure: I/we 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.