The oil market has been tough to read recently. There have been several factors that one would normally assume would push prices higher, yet over the last month, crude has dropped dramatically. As a result, the U.S. benchmark West Texas Intermediate (WTI) is now at an important support level and if a bounce is going to come it is likely to be from here.
There are several reasons, both technical and fundamental, to believe it will.
The technical reasons should be evident from the year-to-date chart below. As you can see, the $64-65 level has provided solid support following declines in the past.
Of course, that doesn’t guarantee that the same will be true this time, but it does make it far more likely that buyers will emerge around that level.
There has already been some evidence of that this morning as we have bounced back above $65 after hitting a low of $64.65 in early exchanges.
Whether this level holds or not though, is more about fundamental factors than any technical analysis. This drop from the $76.90 high a month ago has been based on several things, affecting both supply and demand. On the supply side there has been a feeling that the current strife in the Middle East may have the opposite effect to that normally expected.
The market is used to buying oil on rising tensions in the region, on the quite logical assumption that disputes will disrupt supply. Over the last couple of years, however, the main supporting factor for crude has been the agreement between OPEC and a couple of other key producers to restrict output and force prices higher, and the feeling is that these divisions are deep enough to endanger that agreement. So far though, the agreement has held, and with every day that that remains true the chances of a full breakdown lessen.
Even with fears about the output agreement, this move down is still puzzling given that the U.S. sanctions against Iran are about to take full effect. One would logically expect the loss of Iranian production to push prices higher, but instead we have seen big declines in crude over the last month. There is undoubtedly some “buy the rumor, sell the fact” effect here.
The run up to the highs was largely attributed to the anticipated effects of the sanctions and the long trade got a bit crowded. Once the focus shifted to more bearish concerns the rush for the exit exaggerated the downward move. Still, the embargo on Iranian oil will have an effect. There is a limit to how much production can be stepped up elsewhere to compensate for the loss, and a bounce as the effects are felt looks likely.
The demand-side worries that have added to the bearish mood for oil and been partly to blame for the collapse of stocks also look to be fading. As I wrote yesterday, there are indications that stocks are about to reverse and as that plays out the general return to optimism will spill over into the oil markets. There is already evidence of an increasing risk appetite over the last couple of days and if that isn’t derailed by something like Friday’s jobs report, higher oil is on the cards.
For most investors, while a bounce in oil may add to a welcome relief for stocks, it will have little direct effect but those with a more aggressive investing style may be looking for a way to play an expected bounce in crude. The easiest and most accessible way is through a leveraged ETF such as UWT. There are a couple of things that must be said when talking about this kind of product.
Firstly, the leverage employed means that moves are exaggerated, both up and down, making for substantial risk. Secondly, the fees involved and the effects of contango mean that the fund will not accurately reflect three times the moves in WTI over time. The first issue makes using and sticking to stop losses important, while the second is not a big concern for most people, particularly for a trade like this that will evolve quite quickly.
There is, then reason to believe that crude will bounce before too long. Fundamental concerns that have weighed for a while are shifting, just as the price approaches major support levels. Given that, buying UWT at around 30.40 with a stop around 27.40 and a target around $40 is a trade with an attractive risk/reward ratio and a decent chance of success.