I have been quick to point out the recent supply/demand skew in the oil markets. A large component of my move to the bearish side on June 1st was that the reflation trade was nothing more than a seasonal rise in oil combined with China’s commodity hoarding. There was very little real fundamental strength behind the move. My theory was that this trade would begin to collapse as we got closer to the July 4th holiday and the peak of the summer driving season. And boy did it ever collapse. Not only did China announce that they are no longer heavy buyers, but the peak of the driving season marked the exact peak in oil price.
Meanwhile, the supply/demand skew continues. This week’s EIA data continues to show plummeting demand and increasing supplies. The implications of this are clear. Oil prices have had very little reason to rise over 100% since the beginning of the year. This doesn’t mean they are going back to the panic lows, but rising oil prices simply aren’t rational with the current fundamental backdrop.
Stephen Schork has come to similar conclusions. He is the editor of the Schork Report and one of the finest oil traders around. His analysis of the oil markets is second to none. His latest report is still very bearish as the fundamentals still don’t seem aligned with the technicals. As regular readers know, oil is an important component of the market and could pose a substantial hurdle to any potential upside:
ENERGY PRICES WERE WEAK [this week]… the bottom fell out from underneath the entire complex, again. As such, the bulls in the liquids markets are now down to their last line of defense… the 50/62% retracements (ratio scale). Failure to hold the line here could signal that the real correction is about to kick into gear.
Given extant demand destruction (see last week’s payroll data as the latest in a long list of examples) the current supply of gasoline is sufficient to see the market through to the end of the driving season in early September.
In the middle section of the crude oil barrel supplies of distillate fuels just continue to build and build and build and… supplies last Friday stood at the highest level since the week before Reagan’s second inaugural address (January 21st, 1985). Similar to the situation for gasoline, the lack of demand for on-highway diesel (imports et al.) and off-highway diesel (construction et al.) the current overhang in supply will continue to add ballast to the bull’s ship.
At the same time, crude oil stocks continue to fall. Over the last nine reports supplies have dropped by 28 MMbbls or 7½%. However, as we noted yesterday, there is no reason to think this purge will not continue. In other words, slack capacity utilization is being offset by low domestic production and imports.
Nevertheless, the futures market is showing little regard for this probable drawdown in crude oil. For instance, last night in the wake of that “large” drawdown in crude oil supplies, the contango (the premium afforded the deferred contracts) settled at one of the steepest inclines in two months. In other words, despite ongoing efforts to reduce supply, traders on the NYMEX discounted spot material at a two-month high. Therefore there is very little concern regarding the nearby availability of supply.
Great analysis. Although oil supplies remain abundant we could see some stabilization in the oil market as the market simply appears a bit overdone on the downside after a near 20% drop in short order. This could provide some near-term stability in the weeks ahead, but don’t be surprised when the fundamentals reassert themselves later in the summer.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.