The Crude Conundrum – November 19, 2021

The Crude Conundrum – November 19, 2021
Morgan Lewis Posted on November 20, 2021

Weekly Hard Asset Insights
By David McAlvany

Major U.S. stock markets were mixed this week. The Nasdaq Composite index closed positive and made new all-time highs. The S&P 500 closed slightly positive and is hanging around at levels just shy of its highs. The Dow Jones and the small cap Russell 2000 index, on the other hand, both closed lower and are starting to negatively diverge from other indexes. 

With bubble dynamics in play, a continued melt-up in stocks will come as no surprise. With that said, there are indications that the recent rally off of October lows may be getting tired. U.S. indexes are technically overbought. At the same time, momentum readings are weakening relative to price. The resulting negative technical divergences are typically signals that the short-term trend is getting exhausted. Absent a fresh catalyst, market prices could be set for consolidation or correction. 

Another indication of a tired rally can be seen in market breadth measures. After breadth broke out to the upside in October and early November, the NYSE Advance-Decline Index has turned negative again. In fact, the recent drop in the A/D index indicates that despite higher index prices so far in November, more individual stocks have declined than have advanced so far this month. The same is true on the sector level.

In addition, the deteriorating market internals have occurred in direct coordination with the S&P 500 reaching the upper rail of its rising eight-month trading channel. The upper rail of the trading channel has contained each rally for the last eight months, and reaching it is a strong technical signal for short-term profit taking. As long as price remains within the firmly established trading channel, the overall uptrend will continue to progress in what can be described as an orderly fashion. 

With that said, trading channels eventually break. When we get a break of the channel, orderly price action will quickly turn disorderly. If the break is to the upside through the top of the channel, that will be a strong indication that the current melt-up is transitioning into a more volatile and violent blow-off phase. If the breakout of the channel is to the downside, alarm bells will be ringing across Wall Street, warning that the stock market party may have unceremoniously ended.

The big underperformer this week was crude oil. Long term, the outlook for crude seems to come down to several critical factors. If the current surge of inflation is the start of a larger-degree structural shift towards secular inflation, that will support high oil prices. If the transition to clean energy takes longer than expected and requires more front-end energy demand inputs than expected, that will also support high oil prices. If, as is currently the case, the clamp remains firmly on global oil producers’ cap-ex spending purse, that will certainly support high oil prices. If all of these factors are in play and synchronized, we could see extremely high prices. While these factors will largely dictate the longer-term oil price trend, oil’s near-term fate is much more uncertain.

Oil prices were down 6% on the week to close at $75.94. Oil is now at a key juncture and is testing the October breakout above the critical mid-$70s level. After the trip to its recent mid-$80s high, oil was significantly overbought and overdue for a correction. Given the technical significance to its breakout above the mid-$70s, this correction and breakout back-test are to be expected. The technical picture is only part of the story, however.

Oils’ rally off of the Covid lows has been dazzling. At the height of the global pandemic, oil demand virtually evaporated overnight as a result of the exogenous shock from coordinated global lockdowns and economic closures. In response, oil producers aggressively pulled the emergency break on production to dramatically reduce supply. Subsequently, both the rollback of global lockdowns and restart of the global economy significantly outperformed expectations. As a result, oil demand has come surging back. At the same time, however, oil production has been far slower to increase.

According to the International Energy Agency (IEA), following the record decline of 8.6 million barrels per day in 2020, global oil demand is forecast to rebound by 5.4 mb/d in 2021 and a further 3.1 mb/d next year, to average 99.5 mb/d. By end-2022, demand should surpass pre-Covid levels. On the other hand, even if OPEC+ producers were to fill the gap created by demand growth, output from OPEC+ would still be more than 2 mb/d below 2019 average production. The combination of market expectation for greater than expected demand outstripping a relatively subdued production response has been the catalyst for oil’s spectacular rally off of the pandemic price lows.

In addition to an overdue technical price correction, this week saw the escalation of several fundamental factors that have clouded the near-term crude outlook and interrupted the till-recently firmly entrenched bullish oil narrative. This past week saw fresh concerns emerge over a combination of both weaker short-term demand and near-term supply increases.

On the demand side, recent outbreaks of the Covid Delta variant have prompted travel restrictions and lockdowns in some Chinese cities as well as regions of Europe. As a result, fears are reemerging that another wave of Covid will dampen global oil consumption more than expected.

According to the BBC, days after Austria imposed a lockdown on the unvaccinated, on Friday the country expanded the ordinance and announced a full national Covid-19 lockdown starting on Monday. Austrian Chancellor Alexander Schallenberg said the lockdown would last a maximum of 20 days and there would be a legal requirement to get vaccinated starting in February 2022. The Austrian Health Minister said imposing the lockdown was a “last resort.” Latest figures in Austria show the incidence rate has risen to 1,049.9 cases per 100,000 people in the past week and a record 15,809 cases were reported over the previous 24 hours as of Friday. Elsewhere in Europe, case rates were also spiking in the Netherlands, Germany, Hungary, Russia, and to a lesser extent, in the UK and Italy. With new COVID-19 cases now expected to spread throughout Europe, and possibly beyond, crude oil traders are already starting to price in the possibility of another wave of economic restrictions, lockdowns, and the resulting oil demand destruction.

At the same time, on the supply side, speculation has increased that the Biden Administration will tap the U.S. strategic petroleum reserve (SPR) and that China will also add strategic reserves to supply the market and ease high prices. According to Andrew Tyler, head of US market intelligence at JP Morgan, the Biden Administration is now “likely” to announce a unilateral release of 30mb from the SPR. The SPR release is expected to be delivered over the course of a month, and completed by the end of this year. As to the significance of this U.S. unilateral SPR release, Tyler concludes it amounts to a political statement that might translate to an already priced in $2 reduction of the price of crude.

If, however, an SPR release announcement is not unilateral, but is coordinated with other nations taking similar actions, the analysis changes. According to Reuters, President Biden, in hopes to offer temporary price relief amidst a global energy crisis, recently urged top oil-consuming nations including China, India, and Japan to join in a coordinated effort to release crude stockpiles. Depending on the size, scope, and degree of nation state participation, a coordinated reserve release announcement could be materially impactful to near-term prices. According to Reuters, China’s state reserve bureau on Thursday announced that it is working on a release of crude oil reserves. China’s reserve bureau declined further details and didn’t comment on the U.S. request that the world’s top oil consuming nations tap stockpiles in coordination. Nevertheless, the news spooked oil markets and increased speculation that a more impactful, coordinated, national reserve release could be in the works.

The double-barrel combination of news threatening both a demand hit amid a supply boost, in the context of an already short-term technically vulnerable crude price chart, was a fertile environment for the lower prices that manifested this week. In the near-term, how oil price dynamics play out from here seems dependent on a range of possible outcomes with regard to the new covid wave and government reserve releases. How events unfold, and how crude oil reacts to the key mid-$70s price level will carry important near-term price implications. If oil breaks lower into a more significant price decline, it will help to cool prices throughout the energy sector. If crude quickly resumes its rally back above $80 and beyond, it will contribute to continued upward price pressure throughout the energy complex. Similarly, the evolving price of this linchpin commodity over the coming months will have an outsized impact in shaping the nature and character of our broad global inflationary price environment.

As Warren Buffet observed, “Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”

As last month’s blistering 6.2% CPI inflation reading makes clear, we certainly have “an onslaught of inflation.” The fascinating question that remains is, over the next several months, will lower oil prices cool and subdue inflation, or will inflation light and stoke a fire under crude?

As for weekly performance: The S&P 500 closed the week up 0.32%. Gold was lower 0.90%, silver lost 2.25% on the week, platinum dropped by 4.88%, and palladium was off by 2.10%. The HUI gold miners index lost 3.80%. The IFRA iShares US Infrastructure ETF was lower by 1.45% for the week. Energy commodities were mixed and volatile again. WTI crude oil was off 6.00%, while natural gas gained 5.82% on the week. The CRB Commodity Index was off 0.31%, while copper was down 0.90%. The Dow Jones US Real Estate Index ended the week down 0.36%, while the Dow Jones Utility Average Index was flat, up just 0.01%. The dollar was higher this week by 0.95% to close the week at 96.03. The yield on the 10-year Treasury dropped by 4 bps to close the week at 1.54%.

Best Regards,

David McAlvany
Chief Executive Officer

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