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Sell OIL: A Rare Long Term Commodity ETF Play

Posted
1/23/2014 9:55:00 AM
By: Martin Tillier
Referenced Stocks:OIL

Trading commodities ETFs is generally a short term game. Problems with contango (the situation where long term futures are more expensive than short term) means that such instruments often have a built in small but steady loss that makes them unsuitable for that purpose. This is, of course, less of a problem if one's intention is to short the thing, and I believe there is a good opportunity to do just that right now with the iPath Crude Oil ETF (OIL), which reflects the market price of crude.

First, let's look at the big picture. The price of oil, or pretty much anything for that matter, is a function of supply and demand. On the demand side, improving economic fundamentals in the US, and to some extent globally, have put upward pressure on prices, while on the supply side, the advances in technology that have enabled the shale boom have increased production. These two factors have counteracted each other and kept prices relatively stable.

In theory, then, an increase in supply should put downward pressure on prices, but sometimes markets react in a counter-intuitive fashion. Yesterday saw the first oil flow through the southern leg of the controversial Keystone XL pipeline. Forget the politics for a moment and think about the economics. One of the arguments used by proponents of the project is that it will put downward pressure on prices, benefiting everybody, so what happened yesterday? OIL jumped around 1.8% from 22.24 to 22.64.

I searched for a reason and came across this Wall Street Journal piece. The trader interviewed says that the prospect of increased US supply means that more oil will be available for European markets which will close the gap between Brent and WTI prices. At times I just scratch my head. I mean, that makes sense, but surely that gap should be closed by lower Brent prices as supply increases there, not higher WTI prices. This looks to me like a classic case of a market out thinking itself to justify a move that simply defies logic, or is yet another example of "sell the rumor, buy the fact."

Whatever the short term reasons for that jump, in the long term a greater supply of oil to US refineries will put downward pressure on prices, and therefore on the ETF that tracks them, OIL.

On the demand side, I have made this point several times but it seems to me that, as the energy debate in the US rages on party lines, many people are missing what is happening elsewhere in the world. In many cases, even right wing politicians have embraced "alternative" energy. Angela Merkel, for example, was re-elected last year on a platform that included a fossil fuel-free energy policy for Germany. There will still be demand for oil, and as the global economy improves so that demand will grow, but the days of seemingly endless exponential growth in the use of oil are drawing to a close.

All of this is fine and dandy, but we are talking about a long term strategy, so why should you sell OIL now?

OIL

I believe there are two solid technical reasons to make that trade now. Firstly, the uncomplicated, instinctive chart reading that I generally prefer shows that we are at an important level. This 22.60-70 level has been an area of both support and resistance in the past, so resistance this time would be normal.

Secondly, from a more wonkish perspective, we are very close to 61.8% retracement following the move down from the highs around Christmas time. Now my logical, somewhat cynical self recoils at the thought of some ancient, mystical numbers having significance, but they do, and for one basic reason; people pay attention to them.

So we have, if you will, a "double resistance." This tells us nothing about the likelihood of any long term weakness in oil prices or in OIL, but it does indicate that now may be a good time to act. If, like me, you believe that a scenario of increasing oil supply and demand growth that will be limited will unfold this year, then you will be happy to use these technical signals as an excuse to sell. For once, a long term position in a commodity ETF seems to make sense.