By Nick Cunningham
The 5 percent selloff in oil prices on May 4 serves as a painful reminder that the oil market is still woefully oversupplied. But why such a deep and sudden decline in prices on a single day?
Of course, things are not looking great for oil, with inventories still at such extraordinary levels. But the size of the price decline on May 4 was made much larger because of technical moves in the market.
The initial spark is thought to come from the poor EIA report and growing worries about Chinese demand for all sorts of commodities. But oil prices broke through key resistance levels - 50 and 200-day moving averages - which tend to spark deeper selloffs. Over Thursday night, WTI saw a flash crash, a sudden plunge from $45.36 per barrel to just $43.76 in a matter of minutes, according to CNBC. Prices moved back up a few hours later, but remained at $45 per barrel when trading opened on Friday on the U.S. East Coast.
High-volume trading can commence after prices passed a certain threshold, automatic selling that kicks in when prices become too volatile. But with resistance levels broken, further declines to $42 per barrel are possible, according to John Kilduff of Again Capital. Seaport Global Securities echoed that sentiment, arguing in a research note that WTI faces technical resistance at $45.90 per barrel, but that the next level lower would be at $42.70.
Others went further. "That opens the door to not only lower $40s, but possibly into the $30s," Todd Gordon of TradingAnalysis.com said Thursday on CNBC's "Trading Nation." His voice is notable because in November 2015 he predicted that oil would drop to $26 per barrel, which it did early last year.
"It is now-or-never for oil bulls," The Schork Report said. "They either put up a defense here or risk further emboldening the bears for a run at the $40 threshold."
Just a few weeks ago, sentiment was decidedly bullish, with declines in inventories starting to pick up pace, adding to the growing confidence in an OPEC extension. But now the OPEC extension is being taken for granted, and questions are emerging about whether or not a six-month extension will even be enough. After all, the markets, at this point, are assuming an extension is a done deal. Yet, prices continue to fall.
In the futures market, the contango deepened dramatically in short order, reflecting a sharp drop in confidence that inventories will rebalance later this year. Expectations now point to a "normalization" of oil inventories at some point in early 2018 rather than the third or fourth quarter of 2017.
If six more months of keeping the cuts in place are not enough, maybe OPEC should cut deeper? Sources form the cartel threw cold water on such an idea, leaving the market disappointed on Thursday, accelerating the selloff that was already underway. John Kilduff of Again Capital told CNBC that when the OPEC extension is announced, it could add $2 or $3 to the price of crude oil, a rather unimpressive gain given the magnitude of what OPEC is trying to pull off.
This development highlights the waning influence of OPEC. The cartel engineered 1.2 mb/d of cuts for six months and has posted an impressive compliance rate. And they even brought along 558,000 bpd from non-OPEC countries. But shale is already on its way back, taking up market share ceded by OPEC. Meanwhile, demand is looking rather weak - Chinese demand, U.S. gasoline demand, U.S. auto sales and broader economic growth all pose serious question marks. When the group announced their deal in November, they surely expected to declare Mission Accomplished by June. In recent weeks, they have come to realize that an extension would be needed to bring inventories down.
But by early May, an extension is starting to look like the absolute minimum needed. Extending won't boost prices while a failure to extend will certainly cause them to crash. OPEC is in the unenviable position of making deeper sacrifices on the production side without much reward on price. The alternative is to produce flat out and risk causing a price meltdown again. A lose-lose situation.
Still, a price meltdown is probably a worse situation for them, so an extension still looks likely. "I don't think they have many options," Amrita Sen, chief oil analysts at Energy Aspects Ltd., said in a Bloomberg interview.
"So far OPEC's strategy to draw down inventories has not worked," Neil Beveridge, senior analyst at AB Bernstein in Hong Kong, wrote in a note. "It seems obvious to us that OPEC will need to keep the cuts in place for longer than the next six months if their strategy is to have any chance of success."
The flip side of all the technical trading over the past week is that many of the bullish bets have been liquidated already. Without an enormous volume of outstanding bullish bets, the threat to the downside has been taken care of. Which is to say that oil prices could stabilize prices in the mid-$40s.
And not everybody is so gloomy. Citi and Goldman Sachs predict that oil is probably bottoming out, and in any event, the recent selloff was a technical anomaly. The real story is that the markets are continuing to move towards balance, they say. "It's all technicals," Citi's Ed Morse said. "There's nothing fundamental, nothing has changed in the market." Both see oil prices rising in the months ahead. In fact, WTI and Brent are showing signs of life on Friday, regaining some lost ground during midday trading.
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. I have no business relationship with any company whose stock is mentioned in this article.