- Crude oil prices skyrocketed following Russia's invasion of Ukraine in February.
- Prices have since retreated to levels where they may find support.
- However, seasonal weakness and slowing demand caused by economic uncertainty pose a stiff headwind to a rally.
Oil prices were already tracking higher earlier this year because COVID-era easy-money policies drove demand above stubbornly tight supply. However, the commodity’s big move this year happened when Russia invaded Ukraine in February.
Worry a prolonged War would lead to Russian supply evaporating from global markets faster than the U.S. and the Middle East could replace it caused West Texas Intermediate (WTI) prices to skyrocket to $130 per barrel in March from less than $100 in February and $75 in summer 2021.
Although Western sanctions have limited access to Russian oil, demand destruction caused by high prices, slowing economic activity resulting from interest rate hikes, and ongoing COVID-era lockdowns in China, the second-largest oil importer in the world, were underappreciated. As a result, WTI has fallen to about $85 per barrel or about 35% in the past six months.
Is a short-term rally possible?
The oil price sell-off is an important reminder that the market hates complacency, often punishing participants when they fall victim to groupthink (or, as Real Money Pro’s Doug Kass likes to say, group stink).
It’s also another lesson why second-level thinking is critical. Buying oil because of War may have seemed an easy bet, but that argument failed to remember that commodity prices are elastic to economic activity. They are called cyclicals for a reason.
Energy is usually a winner in the late cycle when demand is so hot that it causes inflation to soar. Conversely, energy is less enticing during the recessionary stage when Central Banks hike interest rates to slow inflation, causing demand to shrink.
Nevertheless, stocks and commodities don’t go up or down in a straight line, and after months of plodding along at lower prices, there’s an argument that oil could have a bit of gas left in the tank.
In “Oil Will Bubble Up and Spill: Make Sure You Time a Trade Right,” Real Money Pro’s Carley Garner explains, writing:
“Oil traders find themselves in a conundrum between the harsh treatment buyers have received on short-lived rallies since breaking below $100 per barrel in July and the obvious trendline support near $80…In the short run, we think buyers might win the battle to garner a less impressive rally than the bulls are used to, but some relief nonetheless.”
Lower oil prices have taken a toll on bulls. As buyers suffered losses, they closed out bullish positions in oil futures. Currently, large speculators hold the “smallest net long position since the 2016 lows, which preceded a $50 rally as speculators rebuilt bullish positions,” according to Garner.
So while overly-bullish positioning was a headwind, low levels of long exposure now could mean that too few expect a rally. If so, it might not take much to spark a bounce.
Back to Garner:
“Some recent events that might give the bulls confidence are recent production cuts made by OPEC+ in an attempt to stave off selling and the Biden administration's mulling of placing large buy orders at and around $80 to replenish the Strategic Petroleum Reserve [SPR]…Further, recent weakness in oil prices can be attributed to demand destruction, largely Chinese Covid shutdowns, but the supply side of the equation has merely moderately improved; this should offer some support to pricing.”
OPEC recently said it’s removing the 100,000 barrels of extra production it added in August. Also, the release of one million barrels of oil per day from the SPR this year to soften prices ends October 21st. So if OPEC more aggressively cuts production from here, it could provide price support, given flows from the SPR spigot could reverse.
Why a rally might be fleeting
Oil price seasonality supports the idea of a short-term rally because, historically, prices peak in early October. However, prices then slide through January as oil demand softens, partly because of the switch-over to winter-grade gasoline, so a rally could be fleeting.
The strength of the U.S. Dollar doesn’t help, either. Since oil is denominated in U.S. Dollars, a higher Dollar puts downward pressure on oil demand because buying power weakens in other countries. Of course, the Dollar could peak soon – it’s had a great run – but it still may remain historically strong, keeping a lid on oil prices.
Back to Garner:
“The unfathomably strong dollar will likely continue to be a headwind to crude oil prices; at least for now. Over the last 60 days, oil futures and the US dollar index futures contract have settled in the opposite direction about 70% of the time. Thus, it doesn't mean that oil can't forge a bounce alongside an extension of the dollar rally, but the stronger dollar will likely act as a plow dragging behind it [emphasis mine].”
Additionally, the technical picture isn’t overly bullish for oil. Following its springtime spike, oil prices have re-entered a trading range on the monthly chart, and the top end of that range may limit the slope and duration of a bounce.
Back to Garner:
“This trendline will attempt to act as resistance to rallies; at this time, that price lies near $93. Yet, support near $80 is just as compelling; the sharp trendline from the March/April 2020 lows came into play as oil tested $80 last week. Adding credence to this support level is the psychological aspect of breaking below prices that, before the war in Ukraine, hadn't been seen since fracking exploded in 2013/2014. This currently leaves the price of oil in a neutral zone between $80 and $93.”
The weekly chart also emboldens Garner’s argument that we could see a bounce off the lower end of the channel that eventually stalls out. Garner writes:
“The line in the sand is clear; assuming $80 continues to hold its ground, there is potential for an upswing.
We aren't in the camp that believes oil prices are going to new all-time-highs near $150, but we do believe the odds are in favor of some seasonal strength that allows price action to explore resistance areas in the mid-to-low-$90s; specifically $93 (downtrend line resistance) and $98/$100 an area that has been pivotal in 2022 as well as during the oil booms in previous decades. If there is a game-changing fundamental story such as China abandoning its zero-Covid policies or a flare-up in violence in oil-producing areas of the world, the price of oil could make its way to the top of the trading range near $114, but this is not expected at this time. If seen, this would likely be a bit of a last hurrah rally and an extraordinary opportunity for bears [emphasis mine].”
How low could oil prices fall if they fail to hold $80? Garner writes, “we maintain the premise that oil will see a $60 handle sooner than most believe possible; we are likely entering a period of price discovery that sees prices rebound moderately into the $90s before selling resumes.”
The Smart Play
Energy stocks have provided a safe harbor for investors this year, but the basket is cyclical and slowing GDP could mean that the best move is to book some profit and reduce exposure if we get the short-term rebound in oil prices that Garner discusses.
On Thursday, transportation Goliath FedEx (FDX) warned investors after the market’s close that it would miss expectations for the current quarter because of shrinking demand, including overseas. Additionally, it pulled guidance for the rest of the year because of its inability to forecast how demand may shape up from here.
That’s discouraging news for oil investors because it suggests less transportation activity, reducing oil demand. As Ned Davis reminds us in “Being Right Or Making Money,” historically, transportation accounts for 27% of total energy use because it's relies so much on petroleum.
We also shouldn't ignore that FedEx’s mea culpa adds ammunition to the argument we’re in a recession, further jeopardizing crude oil demand.
In the U.S., GDP was negative in the first and second quarters, and the Atlanta Fed lowered its GDPNow estimate for Q3 to just 0.5% this week. The trend has been for GDPNow to decline and turn negative ahead of the official negative GDP report, so if this trend continues, we could have three consecutive quarters of negative growth. That's certainly not bullish for oil demand.
Given the increasing recession risk in Europe, OPEC may struggle to cut production quickly enough to prop prices up. Remember, OPEC was forced to cut 4.2 million barrels of daily oil production in the fourth quarter when prices fell from $147 to $32 in 2008. I’m not saying that history repeats, but it can rhyme, so don't get too complacent if oil rallies from here.