Bullish Fundamentals Can’t Prevent A Correction In Oil
By Martin Tillier - Jan 28, 2017, 7:00 AM CST
There are basically two ways to analyze markets and make trading decisions, the fundamental and the technical. Logically speaking, fundamental factors and analysis always have the upper hand, particularly over a longer time period. In the case of crude oil, for example, if supply is outstripping demand the price is going down, no matter what your charts indicate. In the short term, though, as traders pay attention to technical factors they can be enormously powerful. Right now there is a battle going on between the fundamental and technical in the WTI market and, unusually, this looks like one that technical factors will win. Two weeks ago here I predicted higher oil and we did climb from around $51 to $54, but the likely outcome of this battle has caused me to expect another drop from here.
Fundamentals as they stand right now, however, suggest that oil is going up. At the end of November it came as a surprise to many people, me included, that despite differences so sharp that actual wars were being fought, the member countries of OPEC managed to come to an agreement to cut production in a meaningful way. What was even more surprising in some ways was that they managed to secure agreement from several large non-OPEC producers, most notably Russia, to do the same.
Now you can argue that at some point in the future there is a good chance that the agreement will break down, or that U.S. shale producers will simply up production to compensate. The fact is though that…
There are basically two ways to analyze markets and make trading decisions, the fundamental and the technical. Logically speaking, fundamental factors and analysis always have the upper hand, particularly over a longer time period. In the case of crude oil, for example, if supply is outstripping demand the price is going down, no matter what your charts indicate. In the short term, though, as traders pay attention to technical factors they can be enormously powerful. Right now there is a battle going on between the fundamental and technical in the WTI market and, unusually, this looks like one that technical factors will win. Two weeks ago here I predicted higher oil and we did climb from around $51 to $54, but the likely outcome of this battle has caused me to expect another drop from here.
Fundamentals as they stand right now, however, suggest that oil is going up. At the end of November it came as a surprise to many people, me included, that despite differences so sharp that actual wars were being fought, the member countries of OPEC managed to come to an agreement to cut production in a meaningful way. What was even more surprising in some ways was that they managed to secure agreement from several large non-OPEC producers, most notably Russia, to do the same.
Now you can argue that at some point in the future there is a good chance that the agreement will break down, or that U.S. shale producers will simply up production to compensate. The fact is though that both of those things are future possibilities, whereas the cuts are real and happening. That and the expectations of an inflationary environment and faster growth that other financial markets are pricing in post-election create a fundamental background that is supportive of crude prices.
Normally, that would be that…fundamentals win. Circumstances now, however, are different. The technical case for at the very least a sharp correction in oil is so strong that it may well override those conditions.
(Click to enlarge)
First and foremost much of the impact of OPEC’s agreement is already priced into the market. WTI is up around twenty percent, from $45 a barrel at the end of November to over $53 today. Even with the expectation of gradually increasing demand a two percent production cut looks pretty much accounted for at these levels. The fact that we have backed off of the high above $55 would also support that argument.
More important in some ways, and certainly more powerful, is another, often overlooked technical factor, market positioning. Traders and institutional funds right now have a huge bias towards long positions in futures, and typically when that happens it presages a price drop. I have been aware of this for a while, but this week was sent an article that has a vivid visual demonstration of how extreme that situation has become. In this Marketwatch piece by Barbara Kollmeyer the author refers to a series of tweets from Raoul Pal of Global Macro Investor, the most impactful of which was this chart showing speculative oil long positioning (brown) versus price (white).
(Click to enlarge)
As you can see those long positions have spiked to record highs, but what should give the bulls pause is looking back on the chart at what has happened when long positions have spiked in the past. Each time they push sharply upwards there is a drop in price immediately afterwards. Of course it is possible that we have further to go before the correction comes, but trading is about assessing and balancing risk and in this case the downside risk looks to be considerable.
As I said, normally fundamental factors would outweigh anything technical but the above chart makes it hard to argue that prices are about to soar, and makes it very likely that they will drop soon. If just about everybody in the market is long there are very few potential buyers left, and the beginnings of a reversal will cause a rapid rush to exit. That would exaggerate any move down through any level that fundamental analysis suggests is logical. Long oil is the classic “crowded trade”, so this time it looks like technicals could win.
