Oil: Is It Different This Time?

Summary

• Crude oil has traded in a range of roughly $40-$55 a barrel for the last year and a half, however, has failed to breakout on several occasions.
• The supply, demand dynamic appears increasingly more positive for oil, as major producers implement production cuts and the world economy continues to expand.
• Recent inflation data implies that we could see higher gas, heating oil, and other fuel related costs going forward, thus a higher crude oil price as well.
• A technical analysis suggests that crude oil appears to be on the cusp of a major breakout, as several technical indicators have turned decisively positive.
• The combination of numerous favorable fundamental elements coupled with a compelling technical setup, implies that oil and oil related trading vehicles are attractive buys at this juncture.

Source: investing.com

Crude oil has been on a roller coaster ride over the past few years, ranging in price from about $110 per barrel, all the way down to $26 a barrel. Over the last year and a half oil has traded in a relatively narrow range of about $40 and $55. Oil has made several attempts to break out of this pattern, yet every time just when it seemed like the black gold was poised to move higher, it got sold off, back down to the lower end of the range.

Well, nothing lasts forever and with crude oil testing $55 once again, this time it really does look different, as this trading range appears to have exhausted itself. With the materialization of favorable fundamental developments pertaining to crude oil, and a very attractive technical setup, a breakout to new highs appears increasingly likely.

The Supply and Demand Dynamic

The supply and demand phenomenon appears to be the most prevalent price moving factor in oil markets today. And demand for oil appears to be gaining momentum, as worldwide demand grew by 2.3 million barrels per day, or by 2.4% in the second quarter of 2017, higher than previously expected by the IAEA. The IAEA now sees oil demand increasing by 1.6 million barrels or 1.7% for the full year in 2017, and is expecting growth to continue in 2018, with demand increasing an additional 1.4 million barrels, or 1.4%.

The world economy is expanding, as growth is robust and is expected to continue. This year, the world GDP is expected to increase by 4% from $75.278 trillion to $77.988 trillion. Moreover, next year’s growth is projected to be around 5%, expanding the world’s GDP to $81.962 trillion. With this kind of growth in the world economy it is probable that the IAEA’s projections are a bit conservative and a growth rate for world oil demand is could be closer to 2% next year.

Source: billygraham.org

Supply Restraints

One of the primary reasons why oil prices have gathered positive momentum in recent months is because of the Russia, OPEC oil cut arrangement. The major oil producing countries have signed an agreement to essentially cap oil production at a specified level, to prevent oversupply, and to provide price stability in the oil markets. The deal appears to be working, and the countries are planning to extend this arrangement after it expires in March 2018.

Iran Tensions Pose a Possible Supply Disruption

Another element that could further decrease supply in the oil markets are renewed tensions with Iranian. President Trump recently disavowed the nuclear deal reached between Iran and the Obama administration. This suggests that possible frictions between the U.S. and Iran could cause the nuclear deal to fall apart, and thus lead to renewed sanctions on Iran which would likely take supply away from the oil market.

Inflation Heating Up

Aside from the supply and demand picture, other elements such as inflation and dollar strength or weakness play important roles in the overall oil dynamic. Inflation has been trending higher in recent months, with the latest reading coming in at 2.23% yoy according to the CPI. Moreover, wage growth had been increasing as well, with a recent employment report showing 2.9% in wage growth, the highest in about 8 years.

Source: kiplinger.com

This indicates that the overall inflation picture is looking much better for oil going forward. Firstly, oil is priced in dollars and increased inflation ultimately leads to a weaker dollar, which makes oil cheaper to purchase in other currencies. Secondly, inflation signals higher prices in the future, and higher prices going forward equate to elevated gasoline, heating oil and other fuel related figures, and thus a higher crude oil price as well.

Tax Cuts' Implications

It appears that Donald Trump’s massive tax cut initiative is likely to pass into law relatively soon. However, this will undoubtedly add trillions to the already bloated deficits and national deb. Some estimates state that the tax cuts will cost upwards of $5 trillion over the next 10 years, which equates to trillion plus deficits for the foreseeable decade. Higher deficits and a bigger national debt will require large amounts of revenues just to service the growing debt load, which is likely to produce higher levels of inflation.

Future Dollar Expectations

As inflation increases, it is likely that the dollar will begin to weaken once again. The USD has had an impressive counter rally of roughly 4% in recent months. However, despite the strength in the dollar oil has gained significant ground in this time frame as well (roughly 20%). The dollar is likely to move marginally higher here but should begin to lose ground again when signs of inflation become more prevalent, and this should provide an additional boost to oil prices in going forward.

Technical View

A technical image suggest that oil may be in the process of breaking out here. We can see a strong, steady uptrend that began in mid-June, and continues to be well intact. Moreover, we can see that the 50-day moving average recently crossed the 200-day moving average, a very positive technical development which indicates that upward momentum is particularly strong now.

The CCI and RSI are indicating that oil is slightly overbought on a short-term basis, but that does not mean it cannot become more overbought. Overall, the chart is suggesting that a breakout is very likely to occur soon, and rather than a selloff, a consolidation period is probable following the breakout.

Crude Oil 1 Year Chart
Source: stockcharts.com

Crude Oil 3 Year Chart

Crude Oil 5 Year Chart

Bottom Line

With demand expanding at a consistent pace and supply being constrained, it is more likely than not that we will see oil trend higher and establish a new trading range at higher levels going forward. In addition, inflation has been elevating in recent months, suggesting that higher rates of inflation are likely ahead for the U.S. economy.

This implies higher gas prices at the pump and increased rates in other oil related products, which should further support oil prices in the future. Moreover, the technical image appears extremely favorable for oil as a significant breakout to a higher trading range appears probable at this stage. The combination of numerous favorable fundamental elements coupled with a compelling technical setup, implies that oil, long oil related ETFs, as well as various oil companies are attractive investments to accumulate at this juncture.

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Analyst’s 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.

We own stock in certain names in the oil services sector