Bill Cara

Tradable Bottom In Oil?

 
Mid-term Elections in the U.S. provided a one-day catalyst for equity markets. The S&P 500 jumped over +2% on Wednesday, although the index surrendered half of these gains into Friday’s close. Markets rejoiced in seeing an outcome conform to expectations going in. Democrats took the House while Republicans increased marginally their majority in the Senate. The final number of seats in the Senate is still not in (even if control of the two chambers is decided) as races in Florida and Arizona for the U.S. Senate are too close to call and will be disputed (with souvenirs of the 2000 Presidential Election). Trump took to Twitter to denounce fraud in vote counting by the Democrats, but this news event should not play out in financial markets. Aside the election, we had a quiet week in terms of market-moving news. Probably the bigger news event this week will come over the weekend as OPEC meets, as discussed below.

Among the macroeconomic data this week, we saw the ISM Non-Manufacturing PMI come in strong at 60.3 for October (ahead of expectations for 59.0). Any slowing in the economic expansion is not showing up in the survey data. We also saw inflation data come in hot, with the Producers Price Index (PPI) jumping by +0.6% in October to a +2.9% y/y rate. While the Fed did not raise rates this week, it’s a sure bet that the December FOMC will announce a +25bp hike.

The Never A Dull Oil Market

At the close of the week, West Texas Intermediate Crude Oil (WTI) posted a 5th consecutive ugly week (-5.21%) as a bigger-than-expected gain in U.S. crude inventories overshadowed concerns OPEC may cut production this weekend. Oil prices have now fallen 10 straight days, wiping out gains for the year. Since the first week of October, WTI is down -19.5%. We’ll call this yet another Bear Market in oil since the major cycle bottom in early 2016. We also saw -20% draw-downs in the summer of 2016 and into the summer of 2017 (the July-August correction this year stopped around -12%).

The drop in oil prices over the past 5-weeks is getting out of hand and is certainly not reflective of the macroeconomic backdrop. The RSI on the front-month WTI contract hit a 4-year low at 19.

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So why this down-side acceleration in oil prices? Technically, the WTI price sliced through a major support below $64.50/barrel (August swing low). Moreover, WTI managed to get below its 200-day moving average in October (in yellow). The market chatter (beyond the technical movement down) revolved around concerns growing supplies will overwhelm the market, as the U.S. offered nations waivers to continue buying Iranian oil. The Iranian sanctions were supposed to be a game-changer in the market. This is not playing out. In fact, Producers have been attempting to pump as much oil as possible right now to soften the blow of those Iranian sanctions, yet Trump has come out and given waivers. Finally, oil explorers boosted U.S. drilling activity this week. Working American oil rigs rose by 12 this week to 886, the biggest jump since late May, according to data from Baker Hughes. Indeed, it seems that everything is pointing to higher supply, which has killed oil prices of late.

In sum, crude’s slump from its early-October peak above $76 a barrel comes as U.S. production is at a record, OPEC output is at the highest since 2016, more Iranian crude might make it to market than previously thought. In addition, demand growth remains a concern. In other words, oil traders are (over-) reacting to elements that seem temporary to us, and, in any case, these factors are getting overly priced into WTI price.

We also are seeing a surge in oil market volatility. The CBOE/NYMEX Oil Volatility Index has climbed above the highest levels from 2017. Spikes in oil price volatility are entry points. We may not yet have seen the highest level of volatility for 2018, but oil Bulls are best advised to get their buy orders ready.

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Non-Commercial Traders (ie: the Speculators) are holding the lowest number of NYMEX Crude Oil contracts since late 2016. Speculators are systematically wrong at market turning points. Again, we can’t say that Speculators selling oil will get burned right away. However a bottom in the oil market should not be far away based on Commitments of Traders Data.

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Ending panicky slides in price, like seen in WTI over the past 5-weeks, often requires a news-based catalyst. This weekend’s OPEC meeting is the logical candidate. A potential agreement by OPEC this weekend to return to output cuts would mark the second production U-turn for the group this year. For Saudi Arabia — the world’s biggest crude exporter — it would be the third time in recent years that the kingdom has delivered a supply surge only to quickly backtrack on it. It is as much OPEC’s disoriented oil production policy as Trump’s on-and-off Iraq sanctions that are causing this sharp movements in oil prices.

Conditions Are Ripe For An Oil Price Bounce

We have remained bullish on oil prices based mainly on our estimation of where we are in the economic cycle (ie Late Expansion phase). Our case for oil was laid out in our Commentary “The Commodity Super Cycle”. With a booming economy (high demand) and building inflation pressures (good for inflation-sensitive commodity prices), this is logically the time when oil prices should be their strongest. We remain constructive that the above supply concerns will prove temporary and oil prices will stabilize in the coming days. Certainly, OPEC would be happier with stable oil prices above $70/barrel. This weekend, we would expect this desire to be reflected in significant OPEC production cuts.

In terms of crude oil sentiment, we’ve gone from ding dong extremes when WTI was testing $77/barrel to gloom this past week. We should not be more than a couple days from a tradable bottom in oil prices given the sentiment washout.

Trade Recommendation

This week we put on a leveraged trade on WTI via options on the USO tracker. A rebound in oil starting in the coming days could push prices back up above $70 by mid-December. We bought calls expiring on 21 December which gives us time for a moderate paced rally. If WTI gets back above $70, the USO will be above $15. In buying the $13.50 calls, we are targeting $1.50 to $2.00 of upside for a cost of $0.26 per option. Our expectation is that oil prices will rise back to $100/barrel before the next recession chocks off demand. Given this view, if oil prices slip more next week we will sell puts slightly out-of-the-money to recoup the call premium paid and potentially get assigned long USO positions at a very bargain price.

As for other recent trades, we closed out almost our entire position in the MSCI World (VT) Thursday this week for a nice +5.6% gain. We also cut the Philippines (EPHE) and Indonesia (EIDO) by one-half to lock in profits and perhaps offer ourselves an opportunity buy back at a discount.

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