Profit Taking Ends Massive Rally In Crude

U.S. West Texas Intermediate crude oil futures are trading lower on Friday after hitting their highest level since December 7 earlier in the session. Profit-taking is likely behind the weakness. However, there are still lingering concerns over rising U.S. production, and key issues with China that have to be resolved despite favorable trade talks earlier in the week. Underpinning the market are the OPEC-led production cuts.

Bullish Scenario

OPEC and its major ally Russia began reducing output by 1.2 million barrels per day on January 1. It they maintain their discipline, this move should trim the global supply glut and stabilize prices.

Earlier in the week, the US and China ended three-days of constructive trade talks which were productive enough to lead to the scheduling of further negotiations later this month. This news has created enough optimism to drive short-sellers out of the market.

Bearish Scenario

The bearish traders are saying that profit-taking and short-covering have been driving prices higher rather than aggressive counter-trend buyers.

They are also expressing concerns over the health of the global economy especially in China where growth in 2018 and 2019 is expected to be the lowest since 1990. This could pressure demand.

Furthermore, most analysts have downgraded their global economic growth forecasts below 3 percent for 2019. This will also be bad for demand.

Finally, the biggest concerns for bullish traders should be increasing U.S. production, which is expected to climb above 12 million bpd this month, the possibility OPEC and its allies will lose their discipline and US-China trade relations.

Throughout the week, optimism over the outcome of the U.S.-China trade talks helped underpin crude oil prices. However, this small taste of euphoria may already be wearing off. Traders think it's good news that the meeting ended with the groundwork being laid for future meetings, however, if you read between the lines, there are still some major challenges ahead. This could weigh on prices over the near-term.

Conclusion

Crude oil is being driven higher by momentum and short-covering. Given the overall supply and demand balance, the market will continue to move higher until it reaches price neutral territory.

The short-covering is likely being driven by the hope that the US and China will reach a trade agreement. Rallies based on hope tend to fail. Strong rallies need favorable fundamentals. Unless there are some real numbers supporting the current rally, it is likely to fail. At some point, real buyers will be looking for value.

The headlines want traders to think that a deal with China will make all the bearish issues go away, but that won't stop the US from producing. Furthermore, one slip up from the OPEC-led cartel and prices will weaken.

The first leg up from the multi-year low in December was primarily short-covering. There's nothing wrong with that. However, rallies cannot be sustained by short-covering alone. Given the current supply/demand picture, buyers aren't likely to chase this market at current levels when it was over $10 cheaper three weeks ago.

Therefore, start watching for a pullback into a value area over the near-term. The short-term correction may already be starting given the potential technical closing price reversal top on the daily chart on Friday. If this chart pattern is formed then we could see a meaningful correction into a value area. This should attract the new buyers this market will need to take it higher.

We're probably seen the shift in investor sentiment so I don't expect new lows. The best strategy is to wait for a pullback into a value area. If buyers come in on this move then a secondary higher bottom will form. This will provide the structure for a longer-term rally.

Technical Analysis         

Weekly March West Texas Intermediate Crude Oil

(Click to enlarge)

The two week rally has been impressive, but the main trend is still down. There is still a long way to go before the main trend changes to up on the daily chart. Buyers will have to take out $76.29. A trade through $42.67 will signal a resumption of the downtrend.

The minor trend is also down. A trade through $54.98 will change the minor trend to up. This will also shift momentum to the upside.

The main range is $76.29 to $42.67. Its retracement zone at $59.48 to $63.45 is the primary upside target. Since the main trend is down, sellers are likely to return on a test of this zone.

The short-term range is $42.67 to $53.61. Its retracement zone support is $48.14 to $46.85. This is the primary downside target. This is also the value zone where we expect to see aggressive counter-trend buying.

Following a prolonged move down in price and time, the first 2 to 3 week rally is usually fed by short-covering. Once the short-covering dries up, there is a pullback into a retracement zone. New buyers who prefer not to chase the market higher tend to wait for a pullback into the value zone. If successful, they will form a secondary higher bottom.

New buyers and additional short-covering could create the upside momentum needed to take out the short-term high at $53.61 and the minor top at $54.98. Look for an acceleration to the upside on a breakout over $54.98. If buying volume increases on the move then look for the rally to possibly extend into $59.48 over the near-term.