After A Brief Attempt At Consolidation, New Lows In Crude Oil

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About: ProShares Ultra Bloomberg Crude Oil ETF (UCO), Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, SCO, SZO, USAI, USL, USO, USOD, USOI, USOU, UWT, WTID, WTIU
by: Andrew Hecht
Summary

A move lower since October and the market stopped, briefly.

The Russians together with OPEC stopped the falling knife, for one week.

Brent-WTI is not bearish.

Term structure points lower.

A recovery is necessary, or we are going to $42.05 per barrel.

At the beginning of October, it seemed like it would only be a matter of time before crude oil headed back into triple-digit territory. While NYMEX WTI futures traded to a high at $76.90, the nearby ICE Brent futures moved to a peak at $86.72 per barrel. Both of the oil futures markets reached new highs for the year and their highest levels since way back in 2014 when the prices were on their way down from over $100 per barrel.

Sentiment always tends to be at an extreme when a market hits a high or a low, but in the oil market, the early November sanctions on Iran caused many market participants to crowd into long positions. A combination of factors led to a top in oil and a sell-off that many analysts did not see coming. While U.S. President Donald Trump had lobbied the Saudis and OPEC to increase their output of the energy commodity as the price climbed, it seems that an event in Turkey led the world's leading producer to follow his directives in the oil market.

The murder of Jamal Khashoggi, a Saudi national and Washington Post reporter, gave the U.S. leader incredible leverage as the evidence pointed to the involvement of the Crown Prince Mohamed bin Salman. The Saudis likely began selling oil as a matter of survival, to retain the support of the United States. At the same time, the U.S. announced exemptions for eight countries when it came to Iranian crude oil. Disappointed longs headed for the exits in the oil market as U.S. output rose to a record 11.7 million bpd and inventories rose for ten consecutive weeks according to data from the EIA. By the end of November, the price of the nearby NYMEX future contract fell to a low at $49.41 per barrel.

The crude oil market has been highly volatile over the past three months. The most direct route for a trade or investment in the energy commodity is via the futures and options that trade on the NYMEX or ICE futures exchanges. For those who do not venture into the volatile world of the futures arena but still wish to trade or invest with leveraged oil instruments, the ProShares Ultra Bloomberg Crude Oil double-leveraged bull product (UCO) and its bearish counterpart (SCO) provide an alternative.

Since hitting a low and probing below the $50 per barrel level, the price action in the crude oil market has become bearish once again as the end of 2018 approaches. The price could not stage any recovery following the early December OPEC decision to trim output, so it has gone the other way.

A move lower since October and the market stopped, briefly

The price of crude oil sank steadily from the October 3 peak to November 29 when it hit a low at $49.41 per barrel.

Source: CQG

As the weekly chart highlights, the active month NYMEX crude oil futures fell from $76.90 to a low at $49.41 on November 29. The decline took the price lower for seven consecutive weeks. After an attempt at a recovery that took then price a few bucks off the low during the week of the OPEC meeting, the price turned south again, and this week it has taken out the late November low. On Tuesday, December 18 the price of January futures moved to a lower low at $47.27 per barrel, and it continues to decline at the time I am writing this piece. The price of WTI futures made it to a high at $54.55 in early December but failed at that level. Crude oil continues to make lower lows for 2018 as the year is coming to an end. The downward trajectory of the market briefly ran out of steam after the OPEC meeting.

The Russians together with OPEC stopped the falling knife, for one week

The December 6 OPEC meeting and December 7 decision to trim output by 1.2 million barrels per day delayed the inevitable for the price of the energy commodity as it turned a falling knife into a floating feather for a few sessions. The move to address the deteriorating price of oil by the cartel caused a brief pause in selling which returned with a vengeance this week.

As I have written in previous articles for Seeking Alpha, Russia is now the dominant force when it comes to OPEC policies, and the decisions and influence over production come from a triad of the leading producers in Moscow, Riyadh, Saudi Arabia, and Washington DC. U.S. President Donald Trump had been putting mounting pressure on the Saudi Royal Family as the price of oil climbed through the summer months and into early October.

The decision to issue exemptions to eight countries that purchase Iranian crude after sanctions took effect in early November helped the price of oil move lower. Moreover, the murder of Jamal Khashoggi in Turkey provided the U.S. President with an opportunity to put additional pressure on Saudi Arabia to sell the energy commodity in exchange for continued support for the Crown Prince. Saudi Arabia capitulated, and as they sold more crude oil in October and November, the leading producer in OPEC lobbied for the smallest production cut at the December 6 meeting. The mounting evidence of involvement by Crown Prince Mohamed bin Salman in the murder of Khashoggi turned out to be a serendipitous event when it came to Saudi capitulation to U.S. demands.

The OPEC meeting ended on December 6 with no press conference and no decision. The members of the cartel could not come to a consensus on production cuts as the Saudis favored a cut of one million and other members favored a larger cut of 1.4 million. The cartel turned to Russia, who had been helpful since 2016 when it came to reversing the decline in the price of oil that took it to $26.05 per barrel in February 2016. Russia acted as a mediator which resulted in the bull market that came to an end in early October. After Russian oil minister Alexander Novak consulted with President Vladimir Putin, the cartel suddenly decided to compromise and cut output by 1.2 million barrels per day. While OPEC would contribute 800,000 barrels, the Russians and other producing countries under Russia's umbrella cut 400,000 barrels. The compromise included exemptions for Iran, Libya, and Venezuela. The production cut provided a temporary lull in selling as the November 29 low remained a level of support. On December 17 the support gave way and the price became a falling knife again as it traded to the lowest price since September 2017 and could be on course for a test of the June 2017 bottom at $42.05 per barrel on the nearby NYMEX futures contract.

Brent-WTI is not bearish

The Middle East continues to be the most turbulent political region in the world. The tensions and proxy war between Saudi Arabia and Iran, U.S. sanctions on the theocracy in Teheran, and other factors continue to threaten an escalation of actions that could impact the production, refining, or logistical routes in the area that is home to more than half the world's oil reserves. Despite the decline in the price of crude oil, an event in the Middle East that could trigger buying remains a clear and present danger in the energy market.

The Brent-WTI spread has remained strong for two reasons. Many members of the cartel employ the Brent benchmark for pricing their output, and the cut has been supportive of the price of the Brent futures. At the same time, U.S. output has increased to 11.7 million barrels per day and inventories have risen in the United States which weighs on the price of the WTI NYMEX benchmark. The second reason, which has faded into the background, is that the Brent-WTI spread is a barometer of political risk in the Middle East which continues to increase given the potential for rising tensions in the region.

Source: CQG

As the weekly chart of the price of WTI minus Brent nearby crude oil futures shows, the spread between the two benchmarks traded in a range from a $2.97 premium for Brent to an $11.55 premium. At $9.58 on December 18, the spread is closer to the high than the low for this year when it comes to the higher price for the Brent crude oil. On October 3, when the price of WTI rose to its high for the year at $76.90, and Brent reached its peak at $86.72, the premium for Brent traded in a range from $9.12 to $9.57 on the February futures contracts. With the price of crude oil more than 34% lower on December 17, the Brent premium is significantly higher on a percentage basis than it was in early October. While the lower output from OPEC and higher production from the U.S. is the leading reason, the political risk component should not be ignored. The Brent-WTI spread at its current level is not a bearish sign for the price of crude oil.

Term structure points lower

Term structure or the forward curve in crude oil can tell us a lot about the market's perception of supply and demand. Backwardation, where deferred prices are lower than nearby prices, is a sign of a tight market or supply concerns. Contango, where nearby prices are lower than deferred prices is a sign of equilibrium or a glut condition. As contango rises, it often reflects that a market suffers from oversupply.

Source: CQG

The chart of February 2020 minus February 2019 crude oil futures on NYMEX shows that the one-year spread had moved from a backwardation of $3.48 on October 3 when the price was on its high to a $4.16 contango on December 18 as the price of crude oil was moving towards the $47 per barrel level. The price action in the one-year spread from February is a bearish reflection and sign for the price direction of the energy commodity. The February-February Brent spread was trading at a $2.52 contango on December 18 with the 2020 contract at $59.69, and the nearby February 2019 contract at $57.17 per barrel. The narrower contango reflects the production cuts, but the premium for deferred Brent crude oil is also a negative factor when it comes to the path of least resistance for the price of the energy commodity.

A recovery is necessary, or we are going to $42.05 per barrel

At the current price for oil, which is the low for this year, there are some bullish and many more bearish factors at play in the crude oil market at the end of 2018. The market is in desperate need of a relief rally now that the bearish knife has begun to fall once gain. The next level of support is at the $45 per barrel level on NYMEX WTI futures and the June 2017 low at $42.05. Sentiment has turned bearish and the price action in the stock market gas stocked a risk-off environment for most assets which is also weighing on the price of oil adding insult to injury at a time of the year where the price action tends to be seasonally weak.

I have been using the ProShares Ultra Bloomberg Crude Oil double-leveraged bull product (UCO) and its bearish counterpart (SCO) to trade the short-term range in the crude oil market these days. If a recovery is in the cards, UCO will offer a leveraged return on the upside, and if the price is heading to the $42 level, SCO will continue to shine as it has since October 3. The fund summary for UCO states:

The investment seeks to provide daily investment results (before fees and expenses) that correspond to twice the daily performance of the Bloomberg WTI Crude Oil Subindex. The 'Ultra' funds seek results for a single day that match (before fees and expenses) two times (2x) the daily performance of a benchmark. It does not seek to achieve their stated objective over a period greater than a single day. The Bloomberg WTI Crude Oil Subindex is designed to track crude oil futures prices.

UCO is the double-leveraged bullish product while SCO is the bearish took that uses an inverse strategy to create its leveraged inverse returns. The most recent holdings of UCO include:

Source: Yahoo Finance

SCO holds inverse futures and swap positions to capture performance on the short side of the NYMEX crude oil market.

During the most recent rally, the price of NYMEX crude oil futures rose from $49.41 on November 29 to a high at $54.55 on December 4, a rise of 10.40%.

Source: Barchart

While the crude oil market trades around the clock from Sunday night until Friday evening, UCO and SCO only trade when the stock market is open for business each business day. Therefore, there can be lags when the price of oil moves during off-hour times for the stock market which can occur frequently. Around the same period, UCO moved from a low at $16.10 on November 30 to a high at $19.09 on December 7 or a rise of 18.6% which is a bit below its promise of double-leverage.

Meanwhile, the price dropped from $54.55 on December 4 to a low at $47.27 on December 18 which was a decline of 13.3%.

Source: Barchart

Around the same period, SCO rallied from $22.46 to $29.16, a rise of 29.8%, over twice leverage on the downside. The fall from $76.90 on October 3 to $47.27 on December 18 was a drop of 38.5%. Over that period, SCO moved from $12.29 to $29.16 or over 137% higher as it outperformed its twice-levered target.

UCO and SCO are only appropriate for short to medium term trades of a couple of weeks at a time. The price for the leverage is time decay in these instruments, so they will lose value over time.

Meanwhile, crude oil became a sitting duck at the $50 level and the price has resumed its decline. On Tuesday, December 18 it fell to a new and lower low at $47.27 per barrel on the NYMEX January futures. It is a challenge to pick a bottom in any market and crude oil is no exception. Eventually, crude oil will find another bottom at a level where it likely will look its worst. I will be using the UCO and SCO products over the coming days and weeks to go with the flow in the crude oil market.

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.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.