Crude Oil And A Retreat That Makes Sense

|
Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWT, WTID, WTIU
by: Andrew Hecht

Summary

The recovery finds a top.

Inventories drop but above $50 the shale oil flows again.

Open interest flatlines near all-time highs.

Cracks signaled once again.

The sweet spot is a magnet.

Last week in my article entitled, Crude Oil Approaches Resistance, I explained why at above $53 per barrel, nearby NYMEX crude oil futures were likely to run into lots of selling that would take the price back to the $50 level. Last week, May NYMEX futures rolled to June at a time when geopolitical risk was rising. Russia-U.S. relations continue to deteriorate as the U.S. is taking on two of Putin's allies, Syria and Iran. In Asia, tensions have increased between the U.S. and North Korea to a point where the leaders of the rogue nation threatened thermonuclear war.

During times of stress, particularly in the Middle East, the price of oil traditionally rises. However, last week oil fell sharply on Wednesday as the energy commodity made a bee-line for its pivot point at $50 per barrel.

A few weeks ago when oil got down to $47.01 on the nearby NYMEX futures contract, the price became too cheap and a recovery rally followed. This week, a price of over $53 per barrel was just too high and selling at the upper end of what is starting to look like a range around a logical pivot point drove the price of oil lower. Crude oil took the stairs up from March 22 through April 12, and on April 19, the world's most liquid and closely followed commodity took an elevator to the downside.

The recovery finds a top

The recovery in oil ran out of steam last week, and as May futures on the New York Mercantile Exchange rolled to June, the price moved lower towards the $50 pivot point for the energy commodity. Source: CQG

As the daily chart of June oil futures highlights, the price of the now active month contract made it to $54.14 per barrel on April 12 when the bullish charge stopped, and the price reversed. As of Thursday, April 20, June futures were trading at just under $51 per barrel and appear to be on the way to the $50 level once again. The most recent recovery found a top, and since the beginning of the year, there is a developing pattern of lower highs in the NYMEX oil futures market on the daily chart. The short-term momentum indicator, the slow stochastic, has crossed to the downside in overbought territory and now the price is in a downtrend. Source: CQG

Meanwhile, on the weekly chart, oil looks a lot like a range trade and that could be the case for the rest of 2017. The momentum indicator is in neutral territory.

Inventories drop but above $50 the shale oil flows again

Advances in technology have, in many ways, made U.S. shale production a turnkey operation that can quickly respond to changes in the price of petroleum. The lag between ramping up and limiting output as prices rise and fall in the United States is a giant step towards making the nation energy independent.

The market is still feeling the effects of the dip below the $50 per barrel level in the U.S. This week, the American Petroleum Institute reported that oil inventories declined by 840,000 barrels while the Energy Information Administration said they dropped by one million barrels. With the price moving higher in April, it is likely that the shale oil is flowing again and the market will brace for increasing inventories in the weeks ahead.

Meanwhile, open positions in the NYMEX crude oil market have held steady close to all-time highs.

Open interest flat lines near all-time highs

Open interest is the total number of long and short position in a futures market, and for NYMEX crude oil the metric remains at a lofty level. Source: CQG

The monthly chart illustrates that open interest at 2.167 million contracts is just a little lower than all-time highs at 2.228 million in March of this year. Source: CQG

The daily chart of NYMEX crude oil open interest shows that the metric has remained steady despite the selloff in March, recovery in April and the most recent bout of selling in the oil market.

The increase in open interest is likely the result of an expansion of hedging activity from shale producers in the United States as they lock in prices for the future to ensure the viability of their business for the months and years ahead. The forward curve in crude oil all the way out to 2025 displays a price that is north of $50 per barrel. The term structure has allowed for producers to sell a percentage of their future output at a profitable level as production costs have been declining because of technological improvements in drilling and the potential for fewer regulations under the Trump Administration.

Meanwhile, crack spreads or the processing margins for refining crude oil into petroleum products were a signal for the price recovery in March and had again indicated that the price had rallied to an unsustainable level on April 12 when the energy commodity moved to its most recent high.

Crack spreads signaled once again

Both gasoline and heating oil crack spreads were a sign that oil would rally from $47 per barrel in March and that the energy commodity would fall from around the $54 per barrel level in April. Source: CQG

The chart of the June gasoline crack spread shows that the refining margin for turning crude into the fuel rallied in March when oil was moving to lows. The gasoline crack peaked on April 4 at $20.71 per barrel and turned lower. Crude oil subsequently turned south on April 12. Source: CQG

Heating oil crack spreads, which are often a proxy for diesel and jet fuels, also rallied in March signaling demand for the primary ingredient in the production of the oil products causing oil to turn around from lows. However, on April 12 as crude oil hit its high so did the heating oil crack spread, and it too has moved lower supporting a return to the $50 per barrel level for the price of oil.

Crack spreads provided important short-term clues for the path of least resistance for the price of crude oil, which is now in the process of returning to a price which is the sweet spot for WTI sweet crude oil.

The sweet spot is a magnet

NYMEX crude is sweeter than Brent crude as it has lower sulfur content and is easier to refine into gasoline. At the same time, price action in the nearby NYMEX futures market seems to be telling us that $50 is a sweet spot for the sweet crude.

The bottom line when it comes to the international petroleum market is that $50 is almost double the price it traded at in February 2016, when the market traded at the lowest level since 2003. Therefore, the half-century price is a level that will satisfy the world's dominant producers. At the same time, $50 is half the price that the energy commodity traded at in June 2014, and it is a level that consumers can rationalize as fair value.

I believe we will continue to see the price of nearby NYMEX crude oil futures trade around the $50 per barrel level into 2018. The price is satisfactory for both producers and consumers. When it comes to shale production in the U.S., above $50 the oil will flow and below the sweet spot price it is likely that production will decline.

The latest dip in the crude oil price makes lots of sense. While the trend is now lower, if the energy commodity moves too far below the $50 per barrel level I expect that production will slow, cracks will rise, and the price action will repeat its pattern from March and April of this year.

I want to inform you about an upcoming price increase for The Hecht Commodity Report. On May 1, we are raising our price for the first time. Current subscribers and anyone who signs up before April 30, 2017, will lock in our legacy price. For any new subscriber, I am offering a two-week free trial for the report. The Hecht Commodity Report features a detailed report on the major commodity sectors, covering over 30 individual commodity markets, with analysis on the technical and fundamental state of each market. I also share ways to play those conditions. Sign up for The Hecht Commodity Report and have a look before the price goes up!

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.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here