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  Crude Oil: Is $51.67 The Top?
 
  2016-06-20
 

 

Summary

North American production continues to be a positive.

Small political premium.

Technicals have turned.

Products remain iffy.

Is the dollar the key?

Crude oil recently traded to the highest price in 2016 when the nearby NYMEX futures contract traded to $51.67 per barrel. It has been a wild ride for the energy commodity since it made lows at $26.05 on February 11 - the price came within 43 cents of doubling in just four months. However, while there are compelling reasons that support the price of oil, there have been signs that the rally was running out of steam.

The action in commodity markets has been bullish over recent sessions as last week the Federal Reserve pumped more accommodative juice into the raw material markets when another month went by without an interest rate hike. That should be good news for the price of oil, but the energy commodity took the Fed's inaction in stride. The future direction of oil continues to be an enigma as it is feeling both bullish and bearish pressures at the same time.

Crude oil is an economic asset, and it is a geopolitical hot potato at the same time. As a commodity, oil is perhaps the most liquid and closely monitored raw material on earth. Wars have centered around oil for decades, and fortunes have been made and lost. The future direction of crude is a topic of discussion for economists, politicians, and laymen. Everyone is a direct or indirect consumer of crude oil, and the price has a direct impact on equity prices. Therefore, prospects for the future price direction will affect markets across all asset classes. Right now, the path of the price of oil looks as certain as a flip of a coin.

North American production continues to be a positive

The market expected a drawdown in crude inventories of 2.3 million barrels, but when the Energy Information Administration announced a draw of only 933,000 barrels, the price of crude oil fell last Thursday for the sixth straight session. U.S. production has dropped in 2016 as rig counts are down to 337 as of June 17, according to Baker Hughes (NYSE:BHI). When oil was over $100 per barrel, over 2,000 oil rigs were operating. On a year-on-year basis, the number has dropped by 294 rigs. Fewer rigs are positive for the price of crude oil and a direct result of the Saudi-led OPEC policy to rid the market of high-cost producers. The OPEC membership has built market share because of the decline in North American production. However, there are signs that some of the member countries are having production issues.

Venezuela recently experienced the biggest monthly decline in output. Venezuela has the largest reserves of crude oil in the world, but it does not have the technology, workforce or foreign investment to capitalize on its reserves under the current political system. Chaos in the country has become a real problem for OPEC, South America, and the world. Some political analysts are calling the nation "the Somalia of the Americas." Additionally, Nigeria is having real production problems - armed militants and corruption in the country have caused a decline in petroleum output.

Iran has boosted its daily production and has stood in the way of any OPEC production freeze. Iran has stated that it is its sovereign right to increase production after years of international sanctions regardless of OPEC policy or strategy. However, old technology and the lack of foreign investment in the theocracy will likely lead the Iranians to hit a production ceiling shortly.

The production picture for crude oil looks a lot better than it did over the past few years, and the price has reflected better market fundamentals.

Small political premium

The Middle East is home to vast reserves of crude oil. This area is the most politically turbulent region of the world, and the political premium for crude oil remains close to the lowest level in years. The premium for Brent crude, the benchmark for Middle Eastern oil, has dropped to around 60 cents per barrel over recent months - the lowest level since before the Arab Spring in 2010. As the monthly chart shows, Brent crude traded to highs of over a $27 premium to WTI NYMEX crude in 2011 and remained at a significant premium until 2015.

The current political premium for crude oil continues to be very low given the potential for problems in the region of the world that has tremendous influence over the world price for petroleum. I view this as a potentially bullish factor for oil. Meanwhile, bullish production trends and a small political premium are not the only issues that are supportive for the price of crude oil over recent sessions.

Technicals have turned

On the daily chart, NYMEX crude oil was overdue for a correction.The price closed at above the $51 level for only one day - June 8 - and since then, it has moved lower for six straight sessions. Short-term momentum, in the case of the slow stochastic, turned lower on June 9 and oil has followed through on the downside closing last week at the $47.98 per barrel level after trading to lows of $46.40. On Friday, NYMEX August futures put in a bullish key-reversal trading pattern on the daily chart, but the pattern occurred on low volume. While there will be some support at $45, the next area of critical support is at $43.65, the May 10 lows. Open interest has moved marginally lower with price, which was not overly bearish from a short-term perspective. Meanwhile, the weekly chart looks more ominous as the slow stochastic has just crossed into a state of negative momentum in overbought territory. On the weekly pictorial, support is at around $40 per barrel. In my article on oil last week, I pointed out that one issue had me worried about the price of oil and that factor continues to weigh on the price of the energy commodity.

Products remain iffy

Crude oil product prices did a bad job keeping up with the price of the raw crude over recent weeks, and this week they did even worse as losses in both gasoline and heating oil outpaced oil.Last week, the July NYMEX gasoline crack spread closed at the $15.27 level, over $1 below the prior week's closing level. One year ago, this processing spread was trading at the lows of $26.44 per barrel.As the weekly chart illustrates, the July NYMEX heating oil crack spread closed last Friday at around $14.22, around 44 cents below the previous week's close. One year ago, this refining spread was trading at the lows of $18.20.

Both processing spreads are trending lower, and the prices are significantly below levels seen during June of 2015. The weakness in the oil product markets means that either inventory is too high, demand is too low or a bit of both. Consumers do not buy the raw crude oil; they purchase oil products, and weakness in this sector has been and continues to be a negative factor for the price of oil. These crack spreads are also a real-time indicator of the profitability of the oil refining business.Last week, VLO traded to 52-week lows when it hit $50.03 per share in a sign that weak crack spreads are causing profits to drop at refineries.

Furthermore, the recent weakness in airline stocks is another critical factor for the price of an important crude oil product, jet fuel. I believe that the fear of terrorism and travel warnings issued by the U.S. State Department for travel to Europe this summer weigh on the airline business. Less traffic means less demand for jet fuel, and that is another factor that is a negative for the price of the energy commodity.

Is the dollar the key?

All commodity prices move with the strength or weakness in the U.S. dollar. The dollar remains the reserve currency of the world, and the benchmark pricing mechanism for most commodities including crude oil. Given the vote on Brexit this week, it is likely that the dollar and all currencies will experience significant volatility. The dollar was stable last week in the wake of no interest rate hike by the Fed, and it closed close to the lows of the week. The upcoming vote in Europe likely prevented the dollar from moving lower as other major currencies have problems of their own.

I do not think the action in the currency markets will have a serious influence on crude oil prices in the sessions ahead - the dollar will have little effect on the price of oil. All currencies are weak these days as the global economy continues to suffer from low or lethargic growth, which could be supportive for all commodities. Many years of stimulative central bank policy to stimulate economic conditions have taken a toll on fiat or paper money, and currencies around the world have lost value. However, when it comes to crude oil, it is likely that production and demand will determine the path of least resistance for prices in the weeks ahead.

The supply side of the fundamental equation continues to improve for crude oil, but oil product prices are telling us that the ultimate demand side remains weak. Falling gasoline, heating oil, diesel and jet fuel prices may be the reason that $51.67 is a level that is a critical high, for now.

While crude oil is always susceptible to supply-side shocks from exogenous events and the political premium remains low, right now, the market looks like it wants to move lower. Keep your eyes on the relationship between crude oil and oil products to gauge demand over the coming weeks.

 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

 
 
 
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