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What’s Next For Oil - Could This Be The Start Of A Correction?

Saudi Storage at plant

Oil prices are down roughly 20 percent from their high watermark for the year, reached in June, and the next steps could be dicey as a bear market forms.

Crude inventories saw a surprise uptick last week, and gasoline stocks rose for the fifth time in six weeks. Sentiment has become bearish, and speculators have stepped up their short bets and sold off their net-long positions, signs that oil traders think oil has more room to fall. Oil prices are now at their lowest level in three months, and once again the month of July has been a huge disappointment for oil producers, many of whom had assumed that the rebound was underway.

What is next for oil? Elevated inventories will take some time to be worked through, and oil production continues to exceed demand, although the magnitude of that surplus is up for debate. Goldman Sachs sees the strength of the U.S. dollar as the largest threat to oil prices in the near-term, not the record levels of gasoline inventories. If that is true, then maybe everyone should try to figure out what the Fed is going to do next rather than trying to decipher movements in EIA data from week-to-week.

Nevertheless, an estimate from an array of experts shows confidence that the oil price rally will get back on track. Reuters surveyed 29 economists and analysts, and the estimates from them project Brent to average $45.20 in 2016, several dollars higher than the average to date for the year. That means they predict prices to rise in the second half of 2016.

But let’s put all of this aside and take a look at how actual oil traders might view the current situation.

There is a chance that oil has been oversold at this point. If the fundamentals do not necessarily justify a much steeper drop in prices, then speculators sometimes step in to buy on the dip, expecting the selloff to be followed by a correction. The move to buy on the dip can then be self-fulfilling, as traders bid prices back up after hitting a relative low point.

Using typical trading patterns to identify when oil is oversold, the timing of a rebound can be roughly predicted. One method of predicting this is known as the “Closing Price Reversal Bottom.” This occurs when the market opens below the prior day’s closing price, and then the high price and the closing price end up being higher than the prior day’s closing price. In short, it’s a technical way of describing prices bouncing off of a bottom and then moving back up. Related:Oil Relieved As Rig Count Shows Negligible Gain

When this occurs, trading volume rises sharply, indicating a rush of trades as speculators try to close out their short positions and go long. That is then often followed by something like a two to three week correction.

 
(Click to enlarge)

Figure 1, September crude oil

The technicalities are complex, but oil prices are approaching a handful of resistance points at between $38 and $40 per barrel. As oil flirts with these price levels, it would not be surprising to see a wave of trades taking place, with long buyers jumping into the market to take advantage of the low point. Related: Oil Industry Slammed By Disappointing Earnings, Oil Price Plunge

On the other hand, if oil drops through these resistance levels, there could be much more movement on the downside, as the trend line starts to look bearish. The trend line is still up, but as Bloomberg Gadfly notes, the 200-day moving average stands at $40.76. If prices breakthrough that threshold, it is a signal to the markets that the uptrend is reversing.

Nothing about these technical trading theories should be taken as a given, but they offer some clues about what to expect next for oil prices. To summarize, if oil drops to $40 per barrel, it could quickly be followed but a rebound as speculators go long. That could last a few weeks. But if prices drop below that threshold, more losses are likely.

By Charles Kennedy of Oilprice.com

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  • Ed S on August 01 2016 said:
    Dear Mr. Kennedy,

    I just read this article. I notice that you quote Mr. Denning's 200-day moving average. Unless I'm looking at a different chart, the 200-day moving average is $44.76, not $40.76. That's a huge difference and changes the analysis and conclusions.

    Ed

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