Market Contango Leads To A Dangerous Game In Oil

Crude Oil Futures

Sellers hit April Crude Oil futures for a sixth straight day on February 11, driving the market to nearly a fresh 12-year low. Huge supply and new forecasts calling for $20.00 crude over the near-term then a range bound trade into the end of the year were two catalysts cited by traders for the sell-off.

Traders are already pricing in more supply at the Cushing, Oklahoma delivery hub for next week's inventories report. As of February 5, crude inventories in Cushing had reached an all-time high a little short of 65 million barrels, according to the U.S. Energy Information Administration. Private forecaster, Genscape, is already predicting a build of almost 425,000 barrels for the week to February 9.

Activity at the exchange also suggests that prices are headed lower over the near-term with most of the action taking place in the $25 put market. The chart indicates that given the current level of volatility in the market, it may just be a matter of days before these puts will be "in the money". To those new to the futures markets, a put is an option contract giving the owner the right, but not the obligation, to sell crude oil at a specified price within a specified time. So this means that traders are so bearish that they are buying the right to sell crude oil under the current market price.

The thought is also the theme in the futures market where the spread between the March and April contracts in U.S. crude widened nearly 60 cents to as much at $2.80 on February 11. This is a huge discount, called "contango". Typically, in the energy markets the nearby contract is higher than the deferred contracts because crude oil is worth more if you didn't have it today. It's different from markets like corn or soybeans that have the risk in the future.

The $2.80 cent spread represents the largest discount between the two contracts since late 2015. This is a strong indication of tight storage space. Throughout 2015, investors were buying the cheaper nearby futures contract, putting the oil into storage in the hope of selling it later at a higher price. Because of the lack of storage space, producers have no choice now but to keep selling nearby oil lower. Buyers know this and keep lowering the bids. Depending on how much oil for sale hits the market, this activity could lead to a freefall in price.

There was some "friendly" news last week, but traders decided to ignore it after the events in the story failed to materialize. Having been burned several times over the past month on stories about a meeting between OPEC and Non-OPEC countries to discuss production cuts, traders decided to reject rumors that Iran and Russia were ready to discuss the issues.

There was even a rumor hitting the markets on February 11 that claimed that some OPEC countries were trying to achieve a consensus among the group and key non-members for an oil production "freeze". The rumors were quickly put to bed after Iran may have started a price war with Saudi Arabia by offering its crude oil to Asia at a discount to the Saudis. 

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Technically, the main trend is down according to the weekly swing chart. The main trend will not turn up until $51.25 is taken out, but the minor trend will turn up on a trade through $36.28.

During the week-ended January 22, the market formed a closing price reversal bottom that led to the one-week rally to $36.28. On February 11, sellers took out the closing price reversal bottom at $28.76, stopping at $28.74 on the initial break. We're going to have to watch the $28.76 to $28.74 carefully over the near-term.

Typically, breaking a reversal bottom leads to an acceleration to the downside. If we fail to see that follow-through move then this will signal that the buying is greater than the selling at current price levels. Another way to put it is the market ran out of sellers, or became "oversold". This could trigger a strong short-covering rally and will serve as proof that bearish traders favor selling rallies rather than weakness.

If $28.76 to $28.74 is taken out with conviction then the next major targets are the psychological $25.00 level and the steep downtrending angle at $21.25. On the upside, the best resistance is the price cluster at $36.25 to $36.28.

Oil Stocks

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We have a few interesting divergences developing between oil-related stocks and crude oil prices. This may mean that investors are realizing that the oil companies may have reached key value areas, and that they are finally getting a grasp on the impact of lower crude oil prices on their company's bottom-line. 

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In these cases, you can see that the stocks or the ETF did not follow crude oil prices lower during its current sell-off. This could be a sign that buyers are coming in to support these equities or that the selling pressure is subsiding. I can't identify a buy signal yet but the price action suggests that the XLE (S&P Energy Select Sector SPDR Fund), XOM (Exxon Mobil) and CVX (Chevron Corporation) should be on your investment radar.

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