Oil: How low can she go?
Oil has
been taking an absolute hammering over the last few months, falling from around
$110usd a barrel in July to below $60usd currently. This correction has been caused by a combination of factors including an undermining of the traditional oil business dynamic by the explosion in US Shale Oil development, a general lack of demand for oil due to a slowing global economy, with demand according to the Organization for Economic Co-operation and Develoment (OECD) currently at 15 year lows. High levels of stockpiled oil around the globe, and lastly, liquidation of speculative long positions on oil by investors who thought the price would rally and have been caught long and wrong.
The bad news for the oil market is that the first three of the factors mentioned are likely to persist for some time yet, and certainly in the case of oil demand I would expect it to fall substantially from here as the next leg of the GFC starts to bite and undermines the global economy still further. In the case of the speculative liquidation we can see how this is developing by using the Committment of Traders Data (COT) that is published weekly by the US Commodity Futures Trading Commision (CFTC). This data covers a whole range of markets and breaks the ownership of futures and options in each particular market into three categories, commercials, large speculators and small speculators. We have used these charts previously as they can offer great insight into where a market might be heading because of the tendency for commercials to consistently get it right, and for the speculators to consistently get it wrong!
Here we can see the current COT data for crude oil.
We can see the extreme short position by the commercials in July of this year when oil peaked (signified by the red bars), and the fact that they have bought back those shorts and reduced their positions as the speculators have sold out. However, they still hold a sizable short position even after the price falls we have seen, and the general picture is not compelling that a sustainable bottom has been reached. I would expect to see the commercials close out all of their shorts and possibly even go long before the true bottom is found.
Because of oil's pivotal role in todays society, being used in everything from pharmaceuticals to fertilizer and plastics to clothing, as well as its obvious role as a transport fuel, this drop in price has been welcome news with the price falls acting as a tax cut and boosting the cash in our pocket in a very direct way. According to Bank of America this windfall may be the equivalent of $1 trillion worth of stimulus, no small sum! Unfortunately, the benefits aren't distributed equally, with the stresses found in many of the current oil exporting countries, many of which are either experiencing civil unrest like the countries of the middle east, or are becoming increasingly aggressive in their dealings with their neighbours, like Russia. Most of these countries are entirely reliant upon oil revenues to keep their economies operating, and with oil at $58 many of those countries are financially underwater. This rising tide of unrest, either internal or external, allied to a severe constriction in revenues moving forward does not bode well. During most of the oil price correction many equity markets have rallied, enjoying this oil-based tailwind, but as the fall has became a rout, these fears over the resulting macro issues have grown and overwhelmed the earlier exuberance. The fall in equities over the last few days has directly stemmed from the unresolved question - how low can oil go?
So with a view to answering that question, lets have a look at the current chart of crude oil.
We can see that oil is close to a previous line of support around the mid 50's, we can also see how extremely oversold it is on both RSI and Stochastics, levels last seen at the lows of the GFC. Should those levels give way, the next major support is the 2008 low of $37.57, and should that fail, hang onto your hat!
Whilst these charts give us some idea of levels where support might be found, and how oversold oil currently is, they are no use for giving us a potential target price.
For that we have to turn to point and figure charts.
Here is a long term chart of Light Sweet Crude, a particular type of crude oil that is predominant in the US. When I first saw this chart I amost fell over as it is showing a downside count or target of $8.95, which seems incredible. I therefore ran multiple P&F charts over different scales and durations and a figure around $8 to $9 appeared a number of times. This is concerning on a number of levels, the fact that the targets appear on multiple charts gives it more substance, but most importantly, if we actually reach $9 it means that all hell has broken loose in terms of the global economy.
Before we get too carried away, I have to say that P&F charts are not infallible, circumstances can change, targets can be cancelled out and prices can just fail to reach the target. But they can also be incredibly accurate and provide information that no other type of chart can provide.
Whilst the $9 downside target certainly came as a shock I can certainly foresee the reasons why it might happen. Apart from the systemic problems outlined at the start, there is also the issue of a rapidly appreciating US dollar which will continue to exert downward pressure on all commodities, including oil. This, allied to the pending collapse in sovereign debt markets and a deflating global economy are more than enough ammunition to drive oil much lower. You should also not be surprised to hear that commodity prices are themselves cyclical and we are currently in the down phase of that particular cycle.
We at least now have an understanding of what might happen, the key will be the support levels. If the mid 50's can hold and a concerted rally occur there is a chance that the technical damage can be undone. My gut feeling is that oil will go much lower, though not necessarily in a straight line and not necessarily now.
Have a wonderful Christmas and a Happy New Year, see you in 2015
