In late January we noted on Jim Cramer's "Mad Money" the fact that speculators had amassed a historically aggressive long position in West Texas Intermediate (WTI) crude oil futures traded on the NYMEX division of the Chicago Mercantile Exchange. At the time we were favoring the idea of a long liquidation that would push prices into the mid-$40s and perhaps even the low $40s. However, roughly seven weeks later we are just now starting to see the cracks in what had been a multi-month trading range.
Although the move took much longer than we had anticipated, we still believe there is an overwhelming propensity for prices to slide sharply as speculators run for the exits. After all, the long positions were justified by traders based on decreasing supplies on the domestic front in addition to OPEC production cuts overseas. Now, however, we are seeing massive inventory builds in Cushing Oklahoma and many observers are questioning OPEC's dedication to its production targets in light of an aggressive shale oil operation in the U.S.
Specifically, the latest inventory report released by the Department of Energy showed supplies rose by 8.21 million barrels to 528.4 million barrels. This is the highest stockpile since data record-keeping began in 1982. Furthermore, U.S. production is at its highest level in more than a year, rig counts are ticking higher, and imports are on the rise.
The oversupplied domestic crude oil market also is putting pressure on Brent crude oil traded in Europe, and sooner rather than later this will make OPEC leaders question their efforts.
All of these bearish fundamental developments are occurring at a time in which traders are holding one of the largest net long positions ever. We can't help but wonder if the infamous Warren Buffett quote "Only when the tide goes out do you discover who's been swimming naked" will soon apply to oil speculators.
The latest Commitments of Traders (COT) report issued by the Commodity Futures Trading Commission (CFTC) revealed large speculators -- those traders categorized as such based on the large quantity of contracts they trade -- were holding roughly 525,000 net long futures. However, if you add small speculators and net option trades, speculators are net long the equivalent of about 585,000 contracts! This figure far exceeds the net long position held by these groups of traders in mid-2014 prior to the mass liquidation that brought crude oil prices from the $110 area to the mid-$40s in a matter of months.
Obviously, it would be impossible for oil prices to decline $60 from the peak long position of speculators last week; such a move would put crude into the negative. Still, it is reasonable to prepare for a move into the mid to low $40s from here, and perhaps even lower if inventories continue to build.
The historical volatility of crude oil futures as well as the implied volatility of oil options had fallen to historical lows prior to Wednesday's plunge. In our experience, prolonged periods of low volatility generally are followed by a massive spike in volatility. Accordingly, we believe the sudden switch from lethargic to lively price action will create a sense of panic, even more than we are seeing now. If so, it could be a catalyst for continued speculator liquidation.
In our January piece, we noted that seasonal tendencies were bullish, which was acting as an antagonist to the bearish case. The thing we failed to mention is that in the few years in which the market trades against its natural seasonality, the moves are generally fierce. In short, counter-seasonal moves in the commodity markets can be devastating; we wouldn't want to try to catch a falling knife just yet.
According to the daily chart, crude oil has broken below trend-channel support near $51.70. Although prices are now oversold based on popular technical oscillators such as the Relative Strength Index (RSI) and Williams %R, we don't trust their accuracy at this time. Long stretches of low volatility cause such technical indicators to be less trustworthy. They often indicate oversold or overbought conditions long before market moves are exhausted. We suspect this is one of those occasions.
Although it won't be a smooth ride or a direct path, we believe the odds are in favor of a decline to the multi-year trend line near $47.50. If fundamentals continue to erode, particularly on the supply side of the equation, we could see oil prices retest the November low of $45.80 and potentially even the July 2016 low of $44.30.