Oil Bears Flummoxed
We recently posted an update on crude oil, entitled “What's Up With Crude Oil?”, in which we shared our technical and sentiment observations on the oil market, as well as our admittedly rather limited knowledge of the market's fundamentals (a number of charts illustrating the fundamental backdrop can be found in this previous article). The in our opinion at the time most important and noteworthy fact was that in spite of the market's healthy technical condition, it was accompanied by a lot of anecdotal evidence showing widespread incredulity at the market's strength. It was no exaggeration to speak of a deeply ingrained bearish consensus. We wrote:
“The main reason to talk about crude oil these days is its stubborn refusal to go lower. There is a fairly widespread anecdotal consensus that prices will – nay, must – come down. In fact, only very recently the US Energy Information Administration (EIA) opined that the sharp increase in US domestic production portends lower prices in the future. It presumably had to point to the future because it is definitely not producing lower prices in the present. In fact, Monday's close in spot WTI at just above $97/bbl. was right at the upper end of its multi-month range and only a hair away from what would be a noteworthy technical breakout. This is evidently not what the consensus would expect, especially in view of the fundamental data accompanying this show of strength.”
(emphasis added)
As often happens in such situations, the market swiftly proceeded to confound the above-mentioned bearish consensus by indeed delivering what we mentioned would be a 'noteworthy technical breakout'. Let us take a look at the charts. On the daily chart, we have penciled in the former resistance zone that has now been broken and should henceforth serve as support on any pullback. Note here that valuable information would also be provided if this level fails to provide support to prices on a pullback. In that case, we would have to label the recent breakout as false, which would be have rather bearish implications.
For now however, the situation is what it is: a clear breakout has occurred. From a technical perspective, one has to remain bullish on crude oil for now, especially as there are no price/momentum divergences in sight yet. The market appears short term overbought, so it certainly looks like it is ripe for a pullback now. Such a pullback will tell us more about the market's underlying strength.
From a technical perspective, crude oil looks set to go even higher – even though a short term pause in the uptrend seems likely – click to enlarge.
The importance of the recent breakout is underscored further by the weekly chart, as crude has now also broken out from a much larger weekly triangle. Admittedly this particular breakout is still small and therefore still potentially susceptible to a reversal:
Crude oil weekly (spot) – numerous triangles in several time frames from short to long term have formed, and the oil price has now broken out in all these time frames. If anything, the weekly time frame chart looks even more bullish than the daily one – click to enlarge.
Needless to say, oil bears (of which there were and still are many) have been rather surprised at this development and are pointing at the recent political upheaval in Egypt as the culprit. Of course, Egypt produces very little oil, so one has to argue that it is the effect the events in Egypt may have on the wider Middle Eastern region that are bullish for oil. As you can see, if one really thinks this through, the idea soon becomes quite a stretch.
Negative Fundamental Data Leave Oil Bears Sticking to Their Guns
In fact, what news there were on the fundamental front – aside from a large inventory draw at Cushing this week that should have had little effect given how huge inventories actually are – the news continue to have a bearish slant. For instance, it was reported that China's oil imports this year have been overestimated quite a bit. Instead of rising as was hitherto assumed, they actually fell in the first half. As is often the case when analyst's expectations prove to be off the mark, everybody is now hoping for a 'better second half'.
That is incidentally the same second half in which the outlook for corporate profits and global economic growth is so bright that mere shades won't be enough to protect our eyes. We will need to put on blindfolds in order to avoid permanent eye damage.
“China's crude-oil imports fell in the first half of 2013, marking the first January-June contraction since the depths of the financial crisis in 2009, but increased refining activity after maintenance work could spur a pickup later in the year.
The oil numbers are part of wider China trade data released Wednesday showing drops in both overall imports and exports for a second consecutive month, with this being the latest of a string of disappointing indicators for the country's economy.
"There is still plenty of time for the second half of the year to have positive growth," said Kang Wu, an analyst at FGE Energy, adding that this could come from increased commercial stockpiling by Chinese refiners.
China imported 138 million metric tons, or an average of 5.6 million barrels a day, of crude in the first half of 2013, preliminary data from the General Administration of Customs showed Wednesday. This was 1.4% less than in the first half of 2012. In contrast, China's crude imports rose by 7% in the first half of 2011 and 11% in January-June 2012.”
(emphasis added)
Leaving the yet-to-happen 'second half' aside, this is best described as 'bummer'. Apparently China's economy is even weaker than everybody thought. In light of these bearish news, many oil bears remain unimpressed by the market's rather impressive (to technicians) breakout. The article excerpted below gives us a nice overview of the current conventional wisdom:
“Analysis: Uptrend in Crude oil price may have little legs. The fundamentals namely, demand does not support the spike in prices, which are led by speculations of political unrest in Egypt disrupting supplies.
The recent rise in crude oil price has surprised many. It comes at a time when the price of most other commodities has been relatively weak, including precious metals like gold and silver, as investors seek to invest in Dollar on the back of US economy gaining strength and the Fed talking of reducing liquidity.
[...]
Nevertheless, even after the army intervention in Egypt, there are no signs of supply disruption. Oil revenues remain crucial and are mainstay for the Egyptian economy and in the backdrop it is most unlikely that the army will disrupt supplies, say experts. Economists at Canadian Imperial Bank of Commerce feel that in Egypt’s case, the temperature gauge may cool rather than heat up in the wake of the military’s move to oust President Morsi. They add, if anything, it could be the first step towards more effective leadership and less political risk. If so, crude oil should give back some of its recent gains.
Besides, although Bernanke's comments saying the US needs highly accommodative monetary policy for the foreseeable future have raised sentiments, fundamentals also do not support this upside. Global supply of crude oil is constantly rising year after year. From around 84.34 mbpd in 2009, global oil supply is expected to average around 89.88 mbpd by end-2013. US production has been increasing sharply. It is up from five mbpd in 2008 to seven mbpd in 2012 to around 7.3 mbpd currently. The European demand remains subdued on the back of economic slowdown. The April-July period, which is peak demand period in US and Europe, has not seen any substantial upside this year, says Soumya Dixit research analyst, at Nirmal Bang.
Demand from China and Japan, too, remains soft. While Brent had seen highs of $119.34 a barrel in February this year in anticipation of strong demand from China and Japan, it later slipped to its 52-week low of $96.79 in April as demand was lower than expected.
Sugandha Sachdeva, AVP- Energy research at Religare Securities, says that it appears crude oil prices are running ahead of the fundamentals and are not taking into account the slew of weak data from China, the world's No. 2 oil consumer. She adds that the prices look all set to test $103.50 in the immediate short run. If it finds support, the counter is likely to make a switch towards $109 mark. But, in case the speculation dilutes, Dixit adds that current $3-4 premium can fade in just 1-2 days.”
(emphasis added)
The problem with this story is of course that it is in large parts exactly the same story bearish analysts have been telling for the past $30 of upside. The only new aspects are the events in Egypt (and we would posit that the widespread assumption that Egypt matters to the price of crude is simply wrong anyway), and the recent news from China, which the market appears to be shrugging off.
We would argue that one aspect that is overlooked here is the vast amount of monetary inflation that has taken place worldwide over the past few years. Whenever the money supply is inflated, some prices in the economy will rise. It is impossible to state in advance which prices will be the greatest beneficiaries of monetary pumping, and there are obviously also cyclical ups and downs, with the 'baton' of price increases at times handed from one market to the next, with some prices still declining even while others are rising, and so forth. And yet, it is clear that without monetary inflation, there could be no price increases on a broad front, and no price can possibly be viewed as being independent of the fact of monetary inflation.
Surprise oil slick fells a few bears.
(Image source unknown)
How Will the Global Economy Cope?
This brings us to the next problem: a rising price of crude oil poses a problem for a large part of the global economy. While oil producers will reap higher profits, the much larger contingent of energy users is left with less discretionary income, respectively faces shrinking profit margins. Due to energy efficiency having increased markedly, the global economy is able to cope with a much higher (real) oil price than in the past. However, over the past 15 years, the price of crude oil is up by nearly 1,000% in nominal terms (again, this would not have been possible in the absence of monetary inflation). That has to be a drag on economic activity – it is akin to a tax increase for the vast majority of businesses and consumers. This is why we are referring to an 'oil slick' in the title of this post – the economy may end up slipping on it.
As an aside, we may once again be treated to the sorry spectacle of central bankers embarrassing themselves in hearings by claiming that 'the rising oil price is exerting upward pressure on inflation'. Ben Bernanke for example made this nonsensical statement on occasion of his Humphrey-Hawkins testimony in 2008. Rising prices are the result of an increase in the money supply, ceteris paribus (i.e. with the demand for money unchanged). In the latter stages of an inflationary era, prices may rise even faster, as the demand for money suddenly evaporates. This usually happens once the public realizes that the authorities have no intention of stopping the inflationary policy.
It should be obvious even to Mr. Bernanke that if the money supply were unchanged, a rise in the oil price would invariably lead to a decline in one or more other prices in the economy, as there would be less money left to pay for other goods. Bernanke claims the exact opposite, which can only be true if the money supply increases to such an extent that price increases on a wider array of goods can be supported. The person ultimately responsible for the growth of the money supply however is Bernanke himself. So instead of saying 'a rising oil price is exerting upward pressure on prices', he should have said: 'my policies are exerting upward pressure on prices, including that of crude oil'.
We cannot say what the 'pain threshold price' for crude oil is today, i.e., the price at which economic activity is so impaired by higher energy costs that the effect becomes noticeable in the data.
We do however know that generally, the economy tends to do better when energy is cheap and abundant than when it isn't. The US economy is in fact receiving a considerable shot in the arm at present from low natural gas prices due to the fracking boom. This is however a local phenomenon – contrary to crude oil, the global fungibility of natural gas is limited, as there is a lack of adequate export and import terminals. Therefore it does e.g. not matter much to Europe that natural gas is cheap in the US, as prices for natural gas imported from Russia remain quite high. It is also likely that current low natural gas prices in the US won't be sustainable for long. Gas drilling activity is already declining, as profit margins for producers are currently too small. Lastly, rising crude oil prices often do have an effect on the prices of other forms of energy to the extent that substitution is possible.
(Image source unknown)
Conclusion:
Crude is currently overbought and we cannot be certain yet whether the recent breakout will hold. However, the mixture of technical strength and widespread skepticism about the sustainability of this strength continues to provide a bullish backdrop. Market fundamentals appear to be bearish, but it seems to us that analysts must be overlooking something. They may not be giving enough consideration to the effects of monetary inflation. It could also be – as we mentioned in our last update – that the disruption of Iranian exports is more important to the supply picture than is widely assumed. Whatever the reason, there is backwardation in the oil futures market, which is invariably a sign that the market is worried about near term supplies.
Currently prices are probably not so high as of yet that they pose a big threat to economic activity, but this could obviously change if prices were to continue to rise in coming weeks and months. A successful test of the recent breakout could set the stage for an even bigger rally, so one needs to keep a close eye on crude oil here.
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