Wednesday's EIA energy report surprised investors with the largest decline in oil inventories since January. Never mind that the domestic supply glut remains at excessively high levels. WTI Crude Oil responded favorably with a +5.13% upside move and made an emphatic key bullish reversal pattern since receding -15.5% when it peaked on March 18th through April 5th's closing price @ $35.89. The US Oil Fund (NYSEARCA:USO), which severely underperformed crude oil futures during the first quarter of 2016 (i.e. USO @ -11.82% vs. Oil Futures @ +3.43%), slightly outpaced the futures contract with a +5.15% performance as it closed at $9.60.
Thursday, it was a different story as traders flinched on reports of a buildup in inventories at the Cushing Oil Hub and an unexpected increase in Iraqi exports. Light Sweet Crude closed @ 37.26 (-0.47 / -1.25%) and the USO closed at 9.51 (-0.09 / -0.94%). Actually it wasn't a different story, it's the same story and here's why:
The numbers (see chart above) from the most recent energy status report appear to support higher prices, but the existing dynamics of supply and demand argue otherwise. The historically high level of inventories will not decline without consistent weekly drawdowns. The only problem with this is that whenever there is a spike in oil prices, sellers (commercials and speculators) are only too eager to sell. In case you haven't noticed, the shale companies aren't the only ones feeling the financial pain of this bear market and a relatively weak global economy suggests that market imbalances will persist and require more time to reach equilibrium.
The demand side of the energy equation does not look that promising. After the United States, the top four net importers of oil are China, Japan, India and South Korea (in this order, depending upon which data source is used for reference). The first two countries are experiencing economic contraction. While India is growing robustly, its GDP represents a fraction of China or Japan and it is still developing the infrastructure that will enable it to import and process more energy. In addition to this, it is dependent upon a favorable global economic environment as more than half of its growth is derived from services. South Korea, which is also exhibiting stable economic growth, is a much smaller economy and like India, its impact on the energy markets is more or less proportionately limited to the size of its economy. Concerning Europe, its positive green shoots are not rooted in terra firma, but are a lab garden experiment engineered by the ECB's dismal scientists to produce a weaker Euro. Whether it can stand on its own and sustain itself when QE (quantitative easing) evaporates is a reasonable doubt shared by many.
On the supply side, OPEC members have very little incentive to reduce production. For starters, none wants to cede their market share, given that a significant portion of their export revenues are derived from energy exports. Besides this, some of these countries, especially those with flat or declining GDP rates, must continually contend with the threat of having their autocracies usurped by extremist theocracies or populist movements that often prove themselves only capable of occupying instead of governing, thus risking further political and economic destabilization.
Of course, the angriest bear (no pun intended) in this entire story is Russia as its heavily weighted energy and metals based economy is completely vulnerable to the boom and bust cycles of commodity markets. Saddled with sanctions to which Putin will never surrender while in power, I suspect that Russia will continue to "drill drill drill" (or "import import import") and "sell sell sell" all the way to hell if need be. Last reported, its annual GDP declined -3.4% and the Central Bank of Russia estimates that it could fall another -5% in 2016 if oil prices remain under $40 per barrel (source: World CIA Factbook).
(As a sidebar note, North American shale producers from the U.S. and Canada are being shaken out of their trees by impending bankruptcies. Those who survive will become even stronger and acquire cost-competitive assets of others who went bust and they will reallocate and deploy them when appropriate. Brazil, another energy producer does not even derive a fifth of its GDP from energy, although it too has its own set of economic challenges before it. )
In conclusion, the existing supply or demand side fundamentals do not support the case for overweighting allocations to crude oil and energy assets in general. The cycle of oversupply has not run its course. Although OPEC members are scheduled to meet with Russia on April 17, in Doha to discuss freezing production at their respective levels, even if an accord is reached, it will not translate into any immediately significant changes to the existing problem of a physically oversupplied market. Not only will it take time to work down the inventories, but also to build trust that all members are complying, if they do at all. For now, the price trend for oil remains bearish unless it can overcome resistance at the 42-43 price levels to confirm that the bulls have regained control of this market.
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