The Pressure Remains On Crude Oil - Current Market Structure Provides Some Mixed Signals

by: Andrew Hecht


Technicals look weak.

Term structure - widening contango.

Brent premium expands as U.S. inventories build to record high.

Processing spreads improve.

There's pressure on producers - demand will determine the path of the price of oil.

Crude oil reached a low of $47.09 on the expiring April NYMEX futures contract on March 14. On Wednesday, March 22 May futures traded to lows of $47.01 per barrel. At the same time, Brent crude fell below the $50 per barrel level for the first time in 2017 as the May ICE futures contract declined to lows of $49.64 before recovering back above the key psychological level.

Crude oil had been rallying, making higher lows and higher highs since the NYMEX contract fell to a low of $26.05 per barrel on February 11, 2016. The latest move to the upside and higher high came in the aftermath of the November 30 OPEC meeting when the cartel with assistance from the Russian, announced they would cut production effective January 1, 2017.

While most OPEC members have stuck to their pledge of lower output, the price appreciated above $50 per barrel and U.S. shale production increased dramatically. The increase in U.S. output and climbing level of inventories prevented the energy commodity from moving above the $55.24 per barrel level, the highs at the very beginning of 2017. NYMEX crude oil futures traded in a $4.53 range from December 19 through the end of February but the weight of rising U.S. production broke the back of oil, and the price declined under $50 per barrel at the beginning of March. Since then, the pressure has been on the price of the energy commodity, and technically it continues to look like lower levels are on the horizon.

Technicals look weak

The long period of consolidation in crude oil ended just over two weeks ago, and the bearish sentiment in the market has increased as the price has dropped. Last week, selling in the equity markets caused many analysts to become even more bearish on the price of the energy commodity, and inventory numbers that pointed to record stockpiles have pushed the price of oil to recent lows. However, while the daily chart looks ugly and like oil could fall off the end of a cliff, there are some signs that the selling could potentially run out of steam, in the short term. Source: CQG

As the daily chart highlights, open interest remains close to all-time highs but both relative strength and the slow stochastic, a momentum indicator, have declined into oversold territory and appear to be turning higher. The current condition of the daily chart points to the rising odds of a technical rally that could take NYMEX crude oil back to the $50 per barrel level or higher. Source: CQG

Meanwhile, the weekly chart indicates that the downside correction is underway as momentum crossed lower in overbought territory. From a weekly perspective, the nearby NYMEX oil futures contract could be on its way to critical support at $42.20 per barrel, the November 15 continuous contract lows. Source: CQG

I believe that the monthly chart is currently the most important pictorial to consider when analyzing the path of least resistance for crude oil. The monthly shows that momentum is turning negative in overbought territory after a rally that began in February and March 2016 that took the energy commodity from lows of $26.05 to double that level. At the $48 per barrel level, the monthly chart is telling us that oil is now at a critical juncture and the next $5 move could determine the price path for many months into the future.

On a technical basis, crude oil looks ugly today, but a rebound in price could put the commodity back on track to continue its consolidation at the sweet spot price of $50 per barrel.

Meanwhile, the forward curve has been moving towards a higher contango over recent sessions which is another bearish sign for the price of oil.

Term structure - widening contango

A widening contango is a sign over oversupply in a commodities market. Contango is a condition where deferred prices are higher than prices for nearby delivery. Source: CQG

As the chart of June 2018 minus June 2017 NYMEX crude oil futures highlights, the spread has moved from a backwardation of 38 cents where oil for delivery in June 2017 was trading at a higher price than June 2018 oil to a $1.38 premium for the deferred futures contract. A widening contango is a sign of oversupply in a market. Source: CQG

The spread between June 2017 and June 2019 NYMEX crude oil has moved from a backwardation of $1.26 per barrel in late February to a contango of $1.33 per barrel. We have seen the same price action in Brent crude oil spreads which have moved from a backwardation to contango for similar periods over recent weeks as the price broke down through the bottom end of the trading range.

As the price of oil moved over $50 per barrel at the end of 2016 and in early 2017, shale oil producers in the U.S. sold future output to guaranty the viability of wells. The hedging activity depressed deferred prices when compared to nearby futures prices. At the same time, production in the U.S. ramped up quickly, and the premium for Brent crude over WTI increased, and U.S. inventories began to grow dramatically. The increase in output was ultimately responsible for the decline in price below the $50 per barrel level. Widening spreads are a sign of a glut market and as the charts illustrate there continues to be a trend of oversupply in the market.

Brent premium expands as U.S. inventories build to record high

Most OPEC members produce crude that prices off the Brent benchmark. Therefore, the production cut caused the price of Brent to outperform WTI NYMEX crude oil. Source: CQG

Before the OPEC meeting on November 30 when the cartel announced a production cut, Brent crude oil futures were trading at a small premium to WTI of 30-40 cents per barrel. The long-term norm for the Brent-WTI spread has been a premium for WTI because the U.S. crude is lighter and sweeter (lower sulfur content) making it easier and cheaper to process into gasoline, the most ubiquitous oil product. However, there are two components to the Brent-WTI spread. The first, and perhaps most important factor is the political or risk premium for oil supplies. An expanding Brent premium at times is the result of concerns about production and logistics for Middle Eastern crude oil. The Middle East is the most volatile region in the world. Following the Arab Spring in 2010, the Brent premium rose to over $25 per barrel as concerns about the political future of the region took center stage. The other component of the Brent-WTI spread comes down to supply and demand. A production cut from OPEC that caused the price to rise above $50 resulted in more shale production which depressed Brent compared to WTI crude. As the chart shows, the Brent premium to nearby May futures now stands at $2.88 per barrel. Traditionally, the Brent premium tends to increase during periods of price appreciation. The $25 premium for Brent came at a time when oil prices were north of $100 per barrel.

Last week, the API reported an increase in inventories of 4.5 million barrels and EIA told markets that total stockpiles rose by 4.954 million to a total of 533.1 million barrels, a new record for stocks. U.S. oil stocks have been rising for months alongside rig counts. As of Friday, March 17, Baker Hughes reported that the total number of rigs in operation in the U.S. stood at 652, a dramatic turnaround from last year at the same time when only 372 rigs were pumping the energy commodity from the crust of the earth. The increase in shale production offset OPEC's production cut, and now the price is back at a level where it was just before the OPEC action in late November. Increasing supply has caused the price of oil to move lower but, recent trends in the oil products markets could provide a silver lining for the energy commodity.

Processing spreads improve

Consumers do not use raw crude oil to fuel cars, heat their homes, bring products to market on trucks, or fuel the planes that transport them all over the country and the world. Oil products are the front line of demand for the energy market when it comes to crude oil, and there are signs that demand is picking up over recent weeks as the price of oil falls.

Last week, the API reported a decline in product inventories as gasoline stockpiles dropped 4.9 million and distillates fell 833,000 barrels. The EIA told the market that gasoline stocks were down 2.811 million and distillate inventories declined by 1.91 million barrels. While crude oil inventories are rising to record levels, we are coming into the peak season for driving in the U.S. and stocks are falling. The crack spread is the processing margin for refining a barrel of crude oil into petroleum products, and those margins have been on the rise. Source: CQG

Nearby gasoline processing spreads have moved from under $10 per barrel in late February to the $19.89 level at the end of last week. The winter season tends to be a time of year when gasoline processing spreads move to lows. Last year at this stage the gasoline crack spread was close to the same level it is at today, while the nominal gasoline price was much lower. Most recently gasoline was trading around the $1.6150 per gallon level while last year it was at under $1.50. The recent drop in inventories and strength in both the nominal price of gasoline and the refining margin are positive signs for demand for oil. Source: CQG

Meanwhile, heating oil crack spreads have rallied over recent weeks as the price of oil fell. The heating oil refining spread ended last week at $15.29 per barrel up from $13.40 at the end of February. Last year at this time the heating oil crack was below $12 per barrel, and heating oil prices were trading at around $1.20 per gallon last year compared to over $1.50 recently on the nearby NYMEX futures contract.

The product markets are telling us that demand is in a lot better shape in the spring of 2017 than it was last year and the refining margins and a decrease in stocks could eventually provide support for the price of raw crude oil. After all, the oil is the input when it comes to the production of the products.

Pressure on producers - demand will determine the path of the price of oil

The recent breakdown in the price of oil has put pressure on nations that depend on oil revenues for survival. OPEC members breathed a sigh of relief when the price rose above $50 per barrel. It was a difficult exercise to come to an agreement to cut production, but the result seemed worth it as the price of the energy commodity responded to their action. However, now that the price is falling once again it should discourage any cheating or over production by cartel members as they have a vested interest in a higher price. Moreover, the Saudis are planning an IPO in 2018 to raise money for their sovereign wealth fund, and a stable and higher price will enhance the valuation of their prized asset, Saudi Aramco. At the same time, the Russians and other oil producers understand that if they begin to produce without abandon once again, they will allow U.S. shale producers to repurchase hedges and profit without the expense of producing a barrel of the future oil that they have sold for deferred delivery over recent months. The U.S. is currently in an excellent position as technology seems to have made energy independence a turnkey operation. If oil falls, the U.S is in the position to import foreign oil at low prices, and if it rises, the shale oil can flow once again in very short order.

Demand will ultimately determine the path of least resistance for crude oil over the months ahead. If U.S. GDP continues to grow and Europe and Asia continue to show signs of economic growth, demand for energy will increase, and the price of oil should rise. OPEC members, particularly the Saudis and the Russians who acted as mediator when it came to the production cut do not want to see the price of oil fall back to $40 per barrel or below. Therefore, it is unlikely that we will see a repeat of a flood the market strategy once again over coming months.

The current state of the oil market presents a mixed picture with some good signs coming from the demand side of the fundamental equation but record inventories and a rising contango indicating a growing glut of oil supplies. I have been arguing that $50 per barrel is a sweet spot for consumers and producers alike. I continue to believe that buying oil on a scale down basis over coming weeks as the current bearish trend dominates price action will eventually yield optimal results. The current market structure for crude oil is presenting traders and investors with mixed signals at this time. The technical picture continues to make a compelling case for a test of support at $42 per barrel. However, at that price, the shale will stop flowing at current levels, and U.S. producers could become buyers rather than sellers adding a layer of support to the market. The next test for oil comes at just below $46 per barrel, the November 14 lows for the May NYMEX futures contract. For the trend of higher lows that has been in place from the February 2016 lows to hold, NYMEX crude needs to hold above $42.20 which I believe is in the best interest of all market participants. $50 is close to double last February's lows and half the price consumers paid in June 2014 and that price is a sweet spot for crude oil that creates a win-win for producers and consumers alike.

I have introduced a new weekly service through Seeking Alpha Marketplace. Each Wednesday I will provide subscribers with a detailed report on the major commodity sectors covering over 30 individual commodity markets, most of which trade on U.S. futures markets. The report will give an up, down or neutral call on these markets for the coming week and will outline the technical and fundamental state of each market. At times, I will make recommendations for risk positions in the ETF and ETN markets as well as in commodity equities and related options. You can sign up for The Hecht Commodity Report on the Seeking Alpha Marketplace page.

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.

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