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To Buy or not to Buy : Thoughts on Crude Oil

Written by Michael Lebowitz and Lance Roberts | Feb 21, 2019

When a team manages a portfolio, as we do at RIA Advisors, investment decisions can be complicated by differing viewpoints. While such debates are frustrating, opposing opinions help make the case to trade or not to trade stronger, which tends to lead to better results.

Currently, Lance Roberts and Michael Lebowitz are discussing the merits of adding crude oil and/or energy stocks to our portfolios. In this article, we share with you part of the debate. We lead with Michael who, while not yet committed, is watching on a key technical signal before pushing for a long position in crude oil and/or energy stocks. The signal is based on the Commitment of Traders Report (COT) published by the Commodity Futures Trading Commission (CFTC). Lance’s opinion, following Michael’s, is based on a fundamental outlook as well as more traditional technical indications. 

Michael’s View

The weekly COT reports details the open interest of a wide variety of commodity futures contracts and options on those contracts. Open interest refers to the net long or short position for each contract or option. Total open interest always nets to zero as there must be a seller for every buyer. To make the report worthwhile the CFTC segments data by the business purpose of each firm or individual that has an open position. The four categories are as follows: Producers, Banks/Brokers, Managed Money, and Other. The net positions of each account type provide valuable information that helps traders understand why a contract is trading the way it is, but also how it might trade in the future.

Many traders pay particular attention to the managed money accounts as they tend to be the marginal transactors, and therefore price setters, in many futures/commodities markets. Frequently, when a large number of managed money accounts are positioned similarly, contract prices ultimately tend to reverse. Such a situation brings to mind the adage about everyone being on one side of a boat.

Currently, the crude oil market is nearing a situation where managed money accounts are relatively bearish. Per the latest COT report for WTI Crude Oil, net longs (the difference between open long and short positions) are at +277,211 contracts. These managers are still net long which can be construed as bullish, but as shown on the graph below, the number of net longs are small in context with COT data since 2014.

As shown by the dotted red line, the current level of net long positioning by managed money accounts is the lowest since 2016. Given that many managed money accounts tend to chase momentum, and oil has fallen 30% since October 2018, the relatively low net long number is not a surprise.

Chasing momentum can be very profitable until it’s not.

When you are trading based on momentum its vital to recognize when the underlying instrument is in an overbought or oversold condition. Conditions can certainly stay overbought or oversold, but at some point, the proverbial boat tips and everyone scurries to the other side. Those accurately anticipating these shifts can profit handily.

The graph below plots the correlation between oil and managed money net positions.

,While some degree of correlation is obvious, it’s not apparent from the graph how well one would do trading solely based on a small net long position. To help, we provide the table below showing price returns for various net position levels over different holding periods. We do this for crude oil and the popular energy ETF XLE, which at times is well correlated to oil. The green highlighted cells represent the best opportunity in terms of length of trade and the net long position.

Unfortunately, COT data is still delayed due to the government shutdown. The CFTC will be reporting twice a week until they catch up. As of early January 2019, the net long position was 277,211, a sharp decline from over 700,000 a year ago.

Lance’s View

Two things are worth considering about the current trend and direction of oil.

The first is simply the long-term dynamics of what is happening with oil.

Currently, the global economy is slowing, and the demand side of the equation is failing to keep up with the growing supply of oil. Despite cuts from OPEC, Russia, and others, the “shale revolution” is adding to supply faster than the cuts to production can account for.

Given that oil is a highly sensitive indicator relative to the expansion or contraction of the economy, and that oil is consumed in virtually every aspect of our lives, from the food we eat to the products and services we buy, the demand side of the equation is a tell-tale sign of economic strength or weakness.

The chart below combines interest rates, inflation, and GDP into one composite indicator to provide a clearer comparison to oil prices. One important note is that oil tends to trade along a pretty defined trend…until it doesn’t. Given that the oil industry is very manufacturing and production intensive, breaks of price trends tend to be liquidation events which have a negative impact on the manufacturing and CapEx spending inputs into the GDP calculation.

As such, it is not surprising that sharp declines in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates.

Since October of 2018, the price of oil has signs of global economic weakness have grown. Despite the occasional rally, it’s hard to see the outlook for oil is encouraging on both fundamental and technical levels.

The charts for WTI remain bearish, while the fundamentals remain basically “Economics 101: too much supply, too little demand.” The parallel with 2014 is there if you want to see it.

The current levels of supply potentially create a longer-term issue for prices globally particularly in the face of weaker global demand due to demographics, energy efficiencies, and debt.

Many point to the 2008 commodity crash as THE example as to why oil prices are destined to rise in the near term. The clear issue remains supply as it relates to the price of any commodity. With drilling in the Permian Basin expanding currently, any “cuts” by OPEC have already been offset by increased domestic production.

As noted in the chart above, the difference between 2008 and today is that previously the world was fearful of “running out” of oil versus worries about an “oil glut” today. The issues of supply versus price become clearer if we look further back in history to the last crash in commodity prices which marked an extremely long period of oil price suppression as supply was reduced.

The fundamental backdrop doesn’t look to improve anytime soon which brings us to the purely technical aspect of oil.

The graph below compares the price of crude oil and energy stocks. As you can see, there is a high correlation between the two. This is not surprising given the impact of the commodity on revenues and profitability for these companies.

From a purely technical perspective, the price of oil remains confined below the 1-year, 2-year, and 5-year moving averages. What this suggests is that prices are going to remain under downward pressures which will likely correspond with the onset of a recession in the next 12- to 24-months.

Again, this is a weekly chart, so things move a bit more slowly. In the very short-term oil is oversold enough, and as Mike noted above, there are certainly catalysts which could push both oil prices and energy-related stocks higher in the short-term.

However, the longer-term backdrop remains negative and corresponds highly with a late stage economic cycle.

As always, “timing is everything.”

Trade Recommendation

Because of the rather weak technical and fundamental outlook for oil that Lance laid out in conjunction with our agreement that economic growth will slow considerably over the next few quarters, we have agreed that patience is the best course of action for now. However, we have not ruled out taking a long position in oil, with a tight stop, if the net long managed money position drops below 225,000.

We will keep you posted if we take any action in oil or energy companies.

2019/02/21
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