Should You be Worried About Oil's Fall?

After a remarkable run up that lasted around a year, the benchmark West Texas Intermediate (WTI) U.S. Crude Oil futures turned tail a couple of weeks ago and lost around twelve percent in ten trading days. The big drop is the result of a kind of perfect storm for crude, with both supply and demand expectations turning bearish.

For traders and investors there are two related questions: how low can oil go, and what does it mean for stocks?

To answer the second question, we must first address the first, and to do that you have to understand what has caused oil to drop so far so fast. The turnaround was prompted by rumors that the agreement to cut production that OPEC and other producers reached in January of last year was in danger. Two of the most productive signatories to that agreement, Saudi Arabia and Russia were reported to be considering increasing production to offset involuntary declines in Venezuela and the expectation that Iranian production will also drop dramatically when the U.S. re-imposes sanctions.

With that momentum in place, the announcement from the White House that tariffs were back on prompted fears that a trade war would negatively affect global growth, and therefore reduce demand for oil.

Those fundamental factors explain the direction change, but the rapidity of the move is a result of technical factors. Net long positions in oil futures have been elevated as a result of the sustained bull market but have been showing slight declines over the last couple of months due to some profit taking.

That leaves those still holding long positions increasingly nervous and more likely to sell into any correction. The momentum that caused was enough to break below the bottom of the long-term channel on Monday.

As you can see from the above chart, two attempts to re-enter that channel have now failed, so the overall technical picture from here is bearish. What you can also see however, is that for there are multiple support levels (marked in yellow) for WTI to get through if the bearish tone is to continue.

That makes it most likely that while we could get to one or two of them, at around $62 and then $60, it will be hard, absent any further fundamental news, for oil to drop much further.

If that news does come it will most likely be during the OPEC meeting scheduled for June 22. So far, the rumors about production increases have been denied and given the success of the cuts in boosting prices so far it is reasonable to assume that those denials are more than just the Saudis talking their book.

On the demand side too, the bad news for oil looks to be exaggerated. There is no doubt that a full-on trade war would depress demand for oil, but there are two mitigating factors.

The first is that oil demand has outstripped supply so far this year, resulting in a significant decline in stockpiles, and continues to do so. Any decline in demand would therefore have to be sizeable to have a big effect. The second is that, on the evidence so far, the likelihood of this White House sticking to its current position for any length of time is slight.

As the International Energy Agency (IEA) said in its latest report, which was written before the drop, the biggest danger to demand was the high price of oil itself. I made the same point here a few weeks ago when I predicted that oil would turn lower. Obviously, that is now less of a concern, so all in all, while testing the support at around $62 is distinctly possible it is likely that we have seen the worst of the declines in crude oil.

In the light of that, the obvious answer to the second main question posed (what this all means for stock investors) is “not much.” Commodity markets tend to be extremely sensitive to expectations for economic conditions, and a sharp fall in oil such as we have seen over the last two weeks can be an early warning sign of trouble to come. In this case though, while there is an element of concern about global growth, most of oil’s declines are attributable to things specific to the oil market.

Equity traders and investors should therefor stay focused on economic and corporate strength for now and ignore oil’s gyrations.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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