Crude Oil And The XLE ETF
Summary
- The XLE led crude oil lower.
- Inventories and processing spreads provide support for crude.
- Rig counts still rising.
- The Aramco IPO and higher oil until Q1 2018.
- The XLE will recover and drive oil back to $50 per barrel.
Crude oil has been under pressure since the May 25 OPEC meeting. When the international oil cartel told markets the production quotas would extend through the end of the first quarter of 2018, the market was disappointed as they had hoped for deeper cuts in output. The price of oil fell below the $50 level on the nearby NYMEX futures contract. Then, when Saudi Arabia and its allies imposed an air, sea, and land blockade on Qatar, the tiny but wealthy oil and gas producing nation, the price headed even lower. Qatar’s relationship with Iran has worried the Saudis, and the move has been an attempt to isolate Iran and their expansionary desires in the region.
Crude oil continued to decline in the aftermath of the blockade of Qatar as the market assumed that increasing rifts within OPEC could lead to a breakdown within the cartel and cheating when it comes to production quotas. In the world of crude oil, selling tends to beget more selling as nations who depend on oil revenues need to sell more when prices slump to stabilize cash flow.
Long before the price of oil fell at the end of May and while it was trading above the $50 level at the end of December 2016, the equities of companies in the oil sector peaked and began to fall. In hindsight, the rise of U.S. shale production caused many of these companies to fall under the weight of increasing supplies around the globe. It turned out that the peak in the XLE last December was a harbinger for the price of crude oil.
The XLE led crude oil lower
While crude oil waited until May 25 to decline under the weight of increasing supplies, the Energy Sector SPDR (XLE) peaked in December and has been falling ever since. 
Source: Barchart
As the chart of the XLE highlights, the ETF product reached a high of $78.45 on December 12, 2016, and has since declined steadily. The most recent low was on July 7 at $63.29, a drop of 19.3% in a little under seven months. While the XLE had been falling, the price of crude oil spent most of its time trading in a range around the $50 per barrel level. During the week of December 12, the energy commodity reached a high of $54.51 per barrel on the active month NYMEX futures contract. 
Source: CQG
The XLE had been making lower lows and lower highs throughout 2017, but the price of oil remained in a trading range until recently. Crude oil fell to a low of $42.05 on the nearby August futures contract on June 21, a decline of 22.9%. While oil has fallen further than the XLE on a percentage basis, the ETF was a bearish sign for the price of the energy commodity.
On Wednesday, July 12 August crude oil futures were trading around the $44.49 level, around 5.8% higher than the recent lows while the XLE was at $64.75 just 2.3% above its low. The XLE continues to tell us that pressure will remain on the energy commodity, but oil is fighting bullish and bearish factors these days.
Inventories and processing spreads provide support for crude
Last week, the crude oil market received some positive news as data releases reported a decline in inventories after the recent price decline. The American Petroleum Institute told markets that stocks fell by 5.76 million barrels for the week ending on June 30. The Energy Information Administration reported an even bigger decline of 6.3 million barrels. In both cases, the drawdowns in stocks were bigger than the market had expected as analysts believed the draws would be around the 2 million barrel level. Moreover, both agencies told markets that gasoline stocks declined with the API data pointing to a 5.7 million withdrawal from stocks and the EIA saying that they fell by 3.7 million barrels. When it comes to distillates, the API stated that they rose by just 380,000 barrels while the EIA’s data showed a 1.9 million barrel decline. The stockpile numbers were enough to stop the decline in the price of crude oil in its tracks last week, and the price has recovered from the June 21 lows at just over $42 per barrel. This week, there was more positive news when it comes to stocks. Crude oil stocks declined by 8.133 million barrels according the API and the EIA said the withdrawal was 7.6 million for the week ending July 7. Both reported declines in gasoline stocks, but distillate inventories increased. The second straight week of declines that were above market expectations have held the price of oil above recent lows.
Meanwhile, the news for crude oil when it comes to oil products has not been bearish as crack spreads have moved significantly higher since June. 
Source: CQG
The daily chart of the gasoline processing spread illustrates that it has moved from $14.64 on June 15 to highs of $18.99 on July 11, and was trading at over $18 on July 12. 
Source: CQG
The heating oil crack spread traded to lows of $13.51 on June 6 and rose to highs of $17.24 on July 5. The heating oil refining spread was trading at $16.39 level on July 12. Both of the oil processing spreads have experienced price appreciation during the period when crude oil fell to its recent lows. The price action in the crack spreads is a sign of buoyant demand for products, which often translates to demand for the critical input in the refining process which is crude oil. The decline in inventories and increase in the gasoline and heating oil refining spreads are signs that demand for oil has increased at lower prices which is not a bearish factor for the energy commodity.
Rig counts still rising
The rise in crude oil supply from the shale producing regions of the United States has been a weight around the neck of the price of crude oil. Crude oil fell to recent lows as Baker Hughes reported twenty-three straight weeks of increases in the number of oil rigs in operation. On June 30, the streak was finally broken as Baker Hughes said that rig counts fell by two. However, on July 7, the company reported another increase of 7 rigs increasing the number to 763 which is 412 above last year’s level after the first week of July. NYMEX crude oil futures closed on July 12 at $45.49 per barrel and one year earlier the energy commodity was trading at close to the same level. The rig numbers are certainly not a supportive factor for the price of crude oil, but it is likely that the trajectory of increases seen over the past year is likely to slow with the price of oil below the $50 per barrel level despite technological advances in drilling. The EIA recently projected that oil output in the United States could rise above 10 million barrels per day if the price of oil were to move back above $50 per barrel. The recent drop caused them to amend their projection to 9.9 million bpd. More production is likely to be a depressive factor when it comes to the path of least resistance for the energy commodity over the weeks and months ahead.
The Aramco IPO and higher oil until Q1 2018
Supply and demand issues in the crude oil are pulling the oil market in opposite directions given the most recent data. However, the initial public offering of shares of Aramco stock is coming closer each day. At their May 25 meeting, OPEC extended production cuts through the end of the first quarter of 2018. Saudi Arabia, the cartel’s leading producing member nation, supported the extension. The Saudis cannot be pleased with the recent price action in the oil market as a price below $50 will weigh on the valuation of shares. Saudi Arabia plans to use the proceeds of the IPO for their sovereign wealth fund next year, and the lower price has put additional pressure on the Saudis as well as other members of the cartel. The lower oil falls, the more the chances that oil producing members will cheat and sell more oil than the current quotas call for to maintain cash flow. Crude oil is now close to 10% below the $50 per barrel level on NYMEX futures which means that producers need to sell more than 10% more oil to receive the same proceeds as they were throughout most of 2017. I believe that the Saudis will do everything they can to limit cheating over the coming months as the valuation of the Aramco IPO is at stake.
The XLE will recover and drive oil back to $50 per barrel
There are bullish and bearish factors at play in the crude oil market these days as the energy commodity continues to trade near the lowest price of 2017. The price action in the XLE had been a harbinger of the rising supplies and eventual lower prices for oil. The XLE will likely be the first to signal a recovery as it has been the leader on the downside. Technical support for the XLE is right around the current level at $64 per share and down at $60, the March and April 2016 lows. When oil fell to $26.05 on February 11, 2016, the XLE had traded down to just under $50 the month before in January. While the XLE has weighed on oil over the course of this year, in 2016 the stock market declined dramatically at the start of the year which put additional pressure on oil-related equities. Right now, the oil-patch stocks do not face that problem as equity indices are close to all-time highs. Technical resistance for the XLE has dropped with the price and now stands at around the $66.50 level. I believe that the XLE is close to or will find a bottom sooner rather than later. A turn in the XLE will likely pull NYMEX nearby crude oil back to its sweet spot at around the $50 per barrel level. However, the next move in the XLE is likely to dictate the path for the energy commodity.
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This article was written by
Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup.
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Andy’s writing and analysis are on many market-based websites including CQG. Andy lectures at colleges and Universities. He also contributes to Traders Magazine. He consults for companies involved in producing and consuming commodities. Andy’s first book How to Make Money with Commodities, published by McGraw-Hill was released in 2013 and has received excellent reviews. Andy held a Series 3 and Series 30 license from the National Futures Association and a collaborator and strategist with hedge funds. Andy is the commodity expert for the website about.com and blogs on his own site dynamiccommodities.com. He is a frequent contributor on Stock News- https://stocknews.com/authors/?author=andrew-hecht
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