What the Oil and Copper Rallies Really Mean

 | Jul 09, 2017 | 2:00 PM EDT
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(This commentary originally appeared on Thursday on Real Money Pro. Click here to learn about this dynamic market information service for active traders.)

It is easy to get excited about the crude oil and copper rallies, but taking a step back to look at the big picture puts a dent in our optimism.

Oil prices are range-bound, and will likely stay that way

The crude oil market has carved out a distinct trading range in recent months that has likely wreaked havoc in the accounts of trend traders. It seems just when the price of crude looks to be on the verge of a bullish breakout, the buying dries up and the price collapses. Similarly, last week the price of oil was in a death spiral before finding footing in the $42 area and recovering sharply from the lows. Ironically, the masses have been caught on the wrong side of the trade more often than not, which is exaggerating the volatility at market turns.

For instance, the Commitments of Traders report issued by the CFTC tells us that each time large speculators have increased their net long position in 2017, the price of crude oil has peaked in the low $50s. Similarly, each time these so-called "smart money" traders have trimmed their bullish holdings, the price of oil has rallied back.

Further, analyst commentary has been dizzying in recent months; the oil market has found a way to rebound at the apex of bearish chatter and find a high as the bullish arguments for oil take hold of the general consensus.

Welcome to the trading range we suspect this will continue for the foreseeable future.

Source: Barchart.com

The large speculator group identified in the COT report are those with large positions and assumed to have deep pockets. Most refer to this group as the "smart money" but they have been on the wrong foot this year in crude oil.

Large specs have consistently added to their long positions at market peaks and reduced their long positions near the bottom of a move. Many of them are using trend trading strategies, so their models are designed to "confirm" the trend before jumping in.

Trend trading signals are slow because of the trend confirmation process and often causes them to buy and sell at precisely the wrong time while the markets are range-bound. Eventually, they will be right and the market will break out with a large move. That is where they hope to make their money.

As you can imagine, this type of strategy requires massively deep pockets and a high tolerance for pain to be successful. I have neither, so I am not a fan of this trading style.

Nevertheless, they have cut their net long holdings by almost 40% since February. They will likely continue the pattern of adding to long positions following the current rally, this could push crude oil up another $2 to $3 but if resistance between $49 and $51 holds, as we expect, they will likely be forced to liquidate once again, which could lead prices into the high-$30s.

The seasonal tendencies are relatively neutral this time of year, but we did notice that honing in on the most recent five years of data reveals a propensity for a July slide in oil prices followed by a temporary recovery. It isn't until the fall that the price of oil has a habit of trading substantially weaker. This bodes well for the theory of range trading in the coming months.

Source: MRCI

Earlier this year we cautioned traders about sharp resistance in crude oil in the low $50s at a time in which speculators were too long. We suspected a move to $43ish was in the cards. Now that the move has materialized, we believe the most likely outcome will be a return to the upper side of the trading range near $50.00 per barrel but we have a hard time imagining prices getting much higher. Specifically, we believe sharp selling will return to bring oil prices to fresh 2017 lows.

Keep in mind, the weekly chart is pointing toward resistance near $49.00 and again at $51.00, making this price range a likely reversal area. Unfortunately, the oil market is messy and volatile-- pinpointing the exact reversal point is difficult and when it happens it probably has more to do with luck than analytical skills.

Nevertheless, the charts suggest a break and hold above $50.00 would be out of character. Instead, we believe the prices will retreat from the $50.00 area to retest $40.00. If so, the odds are in favor of a temporary break into the high-$30s. Our tentative target will be $39.00 the first time down.

Our assumptions of another test of $40.00 oil are based on the trendlines and trading channel, but they are confirmed by the Relative Strength Index (RSI), which has been displaying lower highs. This portrays underlying weakness in each of the recovery rallies. Also, the Williams %R is merely neutral despite the massive reversal; the lagging momentum suggests more upside potential in the near-term but it works against the overall health of the up move.

We like to confirm our findings on a daily chart and identify any potential differences in the analysis. In this case, the daily chart is pinpointing similar resistance areas of $49.00 and then $50.50. Also, oscillators on the daily chart are proposing the oil market isn't far away from being overbought.
The Williams %R is already above 70 (anything over 70 is considered overheated) and the RSI is near 60 (a reading over 70 is considered overbought). Thus, it will be hard for the oil bulls to continue buying into a market that is overbought and approaching technical resistance.

Copper prices will likely fall back to $2.50

Any patriot is partial to higher copper prices. After all, the copper market is seen as a bellwether of the U.S. economy. If copper prices are firm, it is a sign of robust manufacturing and growth. Nevertheless, when we look at the copper chart we have a hard time getting excited about the upside potential for the metal.

Knowing that copper prices trade seasonally weaker from mid-July through early September we have to give significant credence to resistance levels. Yet, we also acknowledge that this leaves two weeks of potential support from seasonal buying. Thus, we can't rule out an erratic run to the $2.85 level to retest the annual high but we are relatively confident the best trades will be from the short side of the market.

The price of copper has rarely traded above $2.75 since 2014. In 2016 and 2017 several attempts at breaking above $2.75 either failed or were short-lived victories. With the price of copper hovering near $2.70, technical oscillators such as RSI and Williams's %R are overbought, suggesting most of the buying is probably behind us.

If we are right about another failure at this level, prices will most likely retreat to the $2.50 area, finding support near $2.60 and $2.55 on the way down.

If there were any doubts regarding our bearish case, a look at the weekly chart paints a clearer picture. Since peaking out in 2011, copper has been in a never-ending bear market consisting of persistent lower highs. Although copper has managed to put together several months of higher lows, the upside remains limited for now.

Technical oscillators such as slow stochastics and RSI on the weekly chart point toward a mildly overheated market in need of a pullback before the bulls have another chance at staging an upside breakout.

In conclusion, the quintessential commodities probably haven't begun a new bull market. Instead, they are simply enjoying an upswing in a bear market. Nonetheless, if prices retreat to support levels ($39 in crude oil and $2.50 in copper) as we suspect, it would be a good time to be a commodity bull.

After all, oil and copper prices are at relative values in the long-run and it would be nice to have a toe in the water when the tide turns.

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