By Jim Hyerczyk
U.S. West Texas Intermediate Crude Oil futures are set to finish lower for the third straight week. What began as a simple pullback in a prolonged uptrend is rapidly becoming a sell-off controlled by factors outside the realm of the traditional fundamentals.
Oil traders usually have the tools to control specific risk or diversifiable risk. This is the type of uncertainty that arises with the commodity you invest in. This unsystematic risk is usually reduced through diversification. When unsystematic risk arises for typical crude oil investors, they have several choices including taking profits, moving stops to protect profits, or spreading their positions with other futures contracts. There is no panic and usually the process is orderly.
In the case of crude oil, investors started to book profits when uncertainty developed over whether there would be a supply shortage.
Crude oil prices rallied over $13 per barrel from late August to early October on the thought that the sanctions against Iran, which start on November 4, would cause a global supply shortage. As of October 3, some analysts were calling for $100 crude oil.
The case for this occurring began to weaken in early October when Saudi Arabia and Russia pledged to offset any shortfall in supply. This fueled the initial stages of the pullback, which was a normal move in any bull market until “systematic risk”, also known as “market risk” or “un-diversifiable risk” hit the market.
Systematic risk started to become a factor in the crude oil market on October 10 – 11 when concerns over rapidly rising U.S. Treasury yields fueled a steep drop in U.S. equity markets. This sent volatility to heightened levels which spread across all markets including currencies and commodities. Other factors contributing to the increase in volatility including lingering concerns over the U.S.-China trade dispute, simmering tensions between the European Union and the Italian government over budgetary issues and Saudi Arabia’s involvement in the death of journalist Jamal Khashoggi.
All of these factors make great headlines, but the real reason for the sell-off in my opinion was the liquidation by the hedge funds. Government data showed the hedge funds were net long as we approached the October highs. Data since then shows the hedge funds have reduced their long positions and increased their short positions.
What may have started as simple profit-taking because of a gradual change in the fundamentals regarding a potential oil shortage (unsystematic risk) blossomed into aggressive liquidation due to the unexpected stock market volatility (systematic risk). The surprise drop in equity markets led to margin calls which may have forced the hedge funds to dump profitable crude oil positions in order to raise much needed cash. This changed what was a normal correction on the longer-term charts into a change in trend on the shorter-term charts.
Once the volatility settles, crude oil traders will be faced with another dilemma. On Friday, the narrative shifted to concerns about the market being oversupplied soon while losses in the global equity markets steepened, increasing worries about demand.
Some analysts maintain the fundamentals in oil remain broadly bullish because of the U.S. sanctions against Iran’s oil exports. However, no one can ignore that U.S. crude oil stockpiles rose last week for the fifth consecutive week, while gasoline and distillate inventories fell, according to the Energy Information Administration.
These assessments show up on the charts with the main trends up on the monthly and weekly charts and down on the daily charts.
Looking at the charts of various time periods, it looks like the crude oil sell-off is likely to continue until the crude oil market finds value. This is not likely to occur until the stock market volatility slows and investors can return to focusing on the traditional fundamentals.
What I would really like to see is a divergence between the stock market and crude oil. At this time, they seem to be moving in lock-step. Perhaps we’ll see this start taking shape as we approach the start of the sanctions on November 4.
One way to deal with the volatility is to strip it out of the charts by looking at the longer-term charts then working down to the daily charts. You have to remember when dealing with charts is that they represent past data. The charts identify points that can provide information on the trend as well as support and resistance levels. However, the turns in the market are controlled by the buying volume and selling volume. So it is suggested that you watch the price action and read the order flow at each key support or resistance level in order to determine if the buyers or sellers are in control.
If you can’t do it day-to-day then read the CFTC’s Commitment of Traders Report. This will tell you to some degree the positions of the large speculators or hedge funds. They tend to operate on “The Herd Theory” so when one decides to buy, they’ll all start buying.
Monthly Technical Analysis
Monthly Nearby WTI Crude Oil
The main trend is up. The last major bottom occurred in June 2017 at $41.34. However, momentum is shifting to the downside with the formation of a technical chart pattern called a closing price reversal top. This chart pattern does not mean the trend is changing. It indicates the selling is greater than the buying at current price levels. It does, however, often lead to 2 to 3 month corrections.
If you look at the 16-month rally from $41.34, you’ll see that it consists of a series of higher-highs and higher-lows, which is essentially the definition of an uptrend.
Throughout the 16-month rally, there have been three, one-month pullbacks. They have created minor bottoms at $63.57, $61.62 and $56.40. If these bottoms are violated, the minor trend will change to down. This will represent a change in the 16-month pattern.
The short-term range is $41.34 to $76.85. If the minor trend changes to down then its 50% to 61.8% retracement zone at $59.10 to $54.90 will become the best downside target or value zone. Since the main trend is up, this zone will likely attract buyers.
The main range is $125.77 to $38.27. Its retracement zone at $82.02 to $92.35 is our primary upside target.
In summary, momentum is shifting to down on the monthly chart. However, the main trend remains intact. Traders using this chart are interested in the long-term trend and will be looking for value on the pullback.
Weekly Technical Analysis
Weekly Nearby WTI Crude Oil
Converting the monthly chart to the weekly chart shows a similar chart pattern except the minor bottoms on the monthly chart are now main bottoms on the weekly chart.
The main trend is also up on the weekly chart. The main trend will change to down when sellers take out the last swing bottom at $63.57. This is followed closely by the next main bottom at $61.62.
The major downside target and value zone for longer-term traders remains the retracement zone at $59.10 to $54.90.
The short-term range is $63.57 to $76.85. Its 50% to 61.8% retracement zone is $70.21 to $68.64. This zone is new resistance. It is controlling the near-term direction of the market. Trading below is giving the market a downside bias.
Up until this week, crude oil was going through a normal 50% to 61.8% correction. The previous week, the market finished inside $70.21 to $68.64. Breaking through the $68.64 level is what triggered the steep decline this week and the shift in momentum. This was likely fueled by sell stops.
Daily Technical Analysis
Daily Nearby WTI Crude Oil
Nearby WTI Crude Oil on the daily chart is in a downtrend. The trend turned down this week when sellers took out a pair of bottoms at $67.66 and $66.58. Prior to that, the market was correcting normally into a series of retracement levels at $70.21, $69.24, $68.04 and $67.44. These levels are new resistance. Therefore, any rally is likely to be labored until buyers can clear out $70.21.
The interesting part of the daily chart is highlighted by the “red arrows”. Buyers have tried to consolidate prices for as many as three sessions before getting hit with a wave of selling pressure. The selling pressure came on days of extreme volatility in the stock market.
So as you can see during this correction, the market could handle normal “unsystematic risk” by exiting positions. It was the “systematic risk” fueled by stock market volatility that has been driving prices sharply lower.
It may well be that the fundamentals remain bullish, but until the systematic risk is eliminated, buyers are going to have a hard time maintaining bullish positions. If the hedge funds can protect themselves from the volatility in the stock market then they won’t be forced to sell crude oil positions in order to raise cash for margin calls. Once they stabilize the situation then they may once again explore the long side of the crude oil market.