by Pinchas Cohen
Irony is when the opposite of what you’d expect would happen happens, often with amusing results. However, oil’s best rally of the year caught traders by surprise (and not the good kind) after the media hype that the commodity had officially entered a bear market. We forecast the plunge in multiple posts over the past month, and we also predicted the correction. At the risk of possibly ruining our record, we provide a third forecast here, this time of the end of the correction and the retesting of the June 21 $42 trough, and an expected decline to $40.
The Fundamental Argument: UBS Says Oil Will Continue to Climb
UBS analyst Giovanni Staunovo forecasts a 20-percent rally by year-end. He argues that market sentiment is overly negative, which means he expects investors to overcome their unwarranted pessimism at some point and increase demand. His main reason, however, is that he believes that supply will be cut, because of OPEC’s pledge to do “whatever it takes” to rein in supply. Staunovo believes that the production deal is beginning to show results, as the IEA reported that demand outpaced supply in the second quarter. That should accelerate in the second half of the year, until the oil market actually rebalances.
US Says Oil Will Decline
First, how can Giovanni think that oil investors have become too negative, right after they just bought it by the barrelful in the year’s longest rally, driving up prices by $10 and paring the year’s worst decline by half?
Second, how can he rely on OPEC & Friends to do “whatever it takes,” after Saudi Arabia itself just violated that pledge in May, shooting down Russian efforts to include an option to extend the deal by three months, as well as disappointing investors by low-balling the cuts. There isn’t an expert who wasn’t surprised at the compliance of OPEC members, since the expectation was members would violate the agreement since they have always done so in the past.
That’s the trend. The current compliance is the anomaly, the correction. If OPEC is willing to do “whatever it takes,” why didn’t they make it part of the deal that they would deepen cuts whenever necessary to offset the rising production from Nigeria and Libya – two members exempt from the deal? How long will other members, who have historically always violated such deals, sit on the sidelines while Nigeria and Libya take advantage of their competitors holding themselves back?
Third, Giovanni sees the initial signs of OPEC’s cuts, because the IEA reported that in the second quarter demand outpaced supply, and it will rebalance by the second half of this year. How, then, does he explain that prices have plunged much lower than where they were before the deal, rendering the deal itself moot? Although prices climbed back above the pre-November 30 OPEC deal, they are still lower than the close on the first day after the deal.
Last Friday, Baker Hughes reported the first rig decline in 24 weeks, by two rigs, which sent oil 2.5-percent higher. But what about the 24 weeks of rig gains? They are the trend, not this one-time decline within the time frame.
The rig count has more than doubled from May’s 316 low. The reports of shale oil companies hedging in order to guarantee them $50 a barrel, compounded with other reports of production being profitable even as low as $20, is where the risk in this market is, not the upside.
The Technical Perspective
Oil has been trading within a falling channel since February. It has executed a dead cross, when the 50 dma (green) crossed below the 200 dma (red) in mid-May and confirmed it when it was retested in June, as the 50 tried crossing over the 200 but fell back. That happened at the start of the 19% $10 drop, between late May and June.
After reaching the bottom of the falling channel, a second dead cross was executed, when the 100 dma (orange) crossed below the 200 dma, putting all three main moving averages in a bearish formation, in which the more recent the price average, the lower it trails, pointing at where price momentum is headed. At this point, oil was due a correction, as short traders realize profits and bottom feeders increased demand.
For readers who point out that the correction didn’t reach the channel top, it’s not a perfect world. The RSI, however, demonstrates that the movement’s momentum had in fact reached the channel top. Oil climbed $5, half of the preceding decline. Most corrections retrace half of the preceding move.
However, even more important than the return percentage is traders’ map of supply-and-demand. The price just so happened to stop at the March trough, then at support. But a violated support often turns into resistance, as short sellers receive confirmation and buyers join the trend, resulting in a downward pressure, where there once was upward pressure.
Another seeming coincidence is that the price stopped dead once, reaching the 50 dma (green), where we forecast the correction is likely to end.
Since beginning research for this article earlier today, the price has plunged 1.6-percent, from a 10th-day gain to what is on course to be the first decline since the June 22 rally. This development also adds the candlestick Bearish Engulfing pattern, which is likely to start a snowball effect of an ever-rising tide of traders questioning whether they have gone too far. Should the correction take place, traders who are still running up with the herd, will run off the cliff and plunge, along with prices, toward the $40 abyss.
Trading Strategies
Conservative traders would probably prefer to wait on a short for a possible return move to the $47 resistance, above which they would place their stop-loss.
Moderate traders may be happy with a return to yesterday’s low of $46.74, which would be almost half of today’s decline, and assume the risk of the other half, with a stop-loss above $47.
Aggressive traders who are willing to take more chances, hoping that whatever losses they incur would be offset and rewarded with less missed opportunities, would likely short now.