The Oil Market Is Facing a Significant Crossroads

The crude oil market quickly shifted from a high demand story to an oversupply story. Ironically, market fundamentals haven't changed much in the meantime, but market sentiment and focus have, and that is all it takes. Although the mood has been altered, speculators are still holding large upside bets on crude oil. In our view, we are approaching an inflection point in which those participating in the overcrowded bullish oil trade will have to decide to liquidate or buy more. Seasonality remains bearish The crude oil bulls undergoing pain and hoping to be saved by outside forces, should look somewhere other than seasonal patterns. As we have noted in previous writings, and will reiterate again, the price of oil generally peaks in October and trades weaker through November and much of December. Even worse, the annual bottom is most likely to occur in late January or February. Thus, aside from a possible December bounce, there isn't meaningful seasonal support for oil until late-winter and the spring months (as the refineries buy oil in the cash market preparing for the summer driving season). QST, Barchart.com, MRCI Even after a $16-dollar decline, oil traders are still too bullish All year we've been talking about the composition of the crude oil market. There has been a perpetually overcrowded bullish trade which, until now, was able to avoid any significant corrections. Yet, even after the sharp decline witnessed in recent weeks, traders are still holding large long positions in the crude oil futures contracts traded on the NYMEX division of the CME Group. Further, sentiment index readings have only moderately softened. For instance, the latest Commitments of Traders Report (COT) issued by the Commodity Futures Trading Commission (CFTC) inferred that large speculators (those with deep pockets holding large positions) were net long roughly 430,000 contracts. To put this in perspective, the net long position held by this group peaked in October near 730,000 contracts, which happened to be an all-time high. In early 2016, this group had liquidated holdings to a low of about 160,000 net long futures. In short, while we have obviously seen a significant amount of liquidation from this group of traders, a continuation of such isn't out of the question. QST, Barchart.com, MRCI Not only does the COT Report suggest there could be more selling by speculators, but market sentiment readings such as the Consensus Bullish Index still pegs market participants as being relatively bullish in crude oil. This index is based on the opinions of industry insiders, newsletter writers, vocal traders, etc. The rule of thumb is a reading near 75% indicates an overly confident market (three out of four polled are bullish). On the other hand, a reading of 25% suggests the market is overly pessimistic (one out of four polled is bullish). Paradoxically, price declines are more likely to happen when most people are bullish and vice versa. The Consensus Bullish Index for oil peaked on the week ending October 12th at 69% and has since declined into the mid-50s. In short, despite the recent selloff most industry professionals are still relatively bullish oil. As a contrarian, this makes me suspect a shake-up could be overdue. A 20% correction in oil feels dramatic, but it is common for oil. Trading commodities isn't the same as trading stocks. They don't have a strong tendency to go up over time nor do they pay dividends. If you are going to speculate in markets such as crude oil, you must be aware of typical behavior. Thus far in 2018, we've seen extremely low volatility in the oil market. I realize, the switchback trading sometimes feels differently, but taking a step back to look at a weekly chart dating back to late 2013 is eye opening for those new to this market. Oil, and many commodities, can slash their value in half, or even a third, in a short amount of time. Likewise, rallies can be irrationally sharp; some might remember oil running from $50.00 to $150.00 in about 18 months in 2006. The weekly crude oil futures chart paints a telling picture; the trading channel that has defined oil prices since the 2016 low will soon be tested. Support is looming near $59.00 per barrel. Keep in mind, in oil and any other commodities, support and resistance levels are not scientific barriers. If the price dips to $58.50 or even a little under $58.00 but then rebounds from there, the level is considered successful. Trading is a game of gray areas, not a black and white venture. If the $59.00 area holds, we suspect prices will eventually make their way back up toward the higher end of the trading channel, which is expected to be near $80.00 by the time prices recover. However, a break below $59.00 could trigger a violent rout into the low $40.00s. After all, oscillators such as the RSI (Relative Strength Index) and Slow Stochastics have yet to fall into oversold territory, nor show signs of bottoming action. If you are doubtful that oil can fall roughly 50% from recent highs, revisit the accompanying weekly chart depicting such declines on three occasions from 2014 through 2016. In fact, the shallow corrections oil traders have grown comfortable with as of late, are arguably the exception rather than the norm. If you are speculating in this market, you must be in tune with the potential worst-case scenario. In our estimation, a move into the $40.00s is not only possible but it is relatively probable. We see a roughly 60% chance of $59.00 support giving way to position liquidation as overzealous bulls come back to earth. QST, Barchart.com, MRCI In summary We mustn't forget the treacherous nature of the crude oil market. Prices have been relatively tame in 2018 but between 2014 and 2016 we witnessed the market cut the value of oil in half on three occasions. I won't be as bold as to suggest we are certain to see the $40.00s by early next year, but weak seasonals, continued overcrowded trade unwinding, and technical action suggests the odds of such are better than a coin toss. Now is not the time to be complacently bullish in crude oil. *THERE IS A SUBSTANTIAL RISK OF FINANCIAL LOSS IN TRADING FUTURES AND OPTIONS.

The Oil Market Is Facing a Significant Crossroads

Speculators are still holding large upside bets on crude oil.

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