Basic economic theory would suggest that pricing of goods and commodities is pretty simple. It is a function of supply and demand. Reduced supply and/or increased demand create scarcity that pushes price up and the opposite is true if supply is increased or demand falters. Anybody who has ever traded, however, knows different. What is usually much more important is the anticipation of such changes. All markets are forward discounting mechanisms, so pricing reflects a combination of the past, present and predicted future of supply and demand conditions. Usually the expectations for the future are the most powerful influence, but at times, and now is such a time in the crude oil market, there are conflicting messages about the future, and something else drives pricing. In this case it is proximity to what is increasingly appearing to be a critical price level.
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That level is, for WTI, somewhere around $51-52. To understand the significance of that level you need to look back at the chart for the second half of last year. At that time WTI was in a long term recovery from the lows below $30 and was being driven higher, in part, by the anticipation of, and then the reality of, supply reductions by OPEC.
Despite that strong influence, however, upward momentum stalled twice at around the $52 level. At the time there were several reports that what was causing that resistance was some big selling, presumably as a hedge, by several large players in the shale market. That would suggest that somewhere around there was a point at which several large U.S. plays could be profitably operated.
Following the election, and the general feeling that a pro-business, and especially pro-fossil fuel business administration in the White House would rejuvenate demand both in America and globally, that level was breached and, as often happens, the resistance level became a support. We traded in a fairly tight range of approximately $52-55 for several months, but gradually something became clear. The OPEC cuts that drove us to that level were being increasingly offset by increases in U.S. production.
As U.S. production continued to increase, so did stockpiles, leaving crude vulnerable to any suggestion of wobbly demand. When that came we quickly dropped back through $52 and momentum carried the price below $50. Once we got there inventory builds slowed and the rig count began to drop. Those indications of reducing U.S. supply along with an increasingly inflationary global outlook pushed prices back to just above $52, where we currently sit.
The point here is that the oil market, for all of its myriad, diverse influences, is actually responding to the most basic economic influence…its own price. It is evident that just over $50 supply is encouraged, and the opposite effect occurs just below $50. The logical conclusion of that is that we will be stuck in a range of around $48-55 for some time. Other factors are roughly in balance right now with geopolitical tensions exerting upward pressure but policy in the U.S. encouraging even more supply increases here.
That may sound to some like a potentially boring market, but for traders it is ideal. A long bias below $50 and a short bias just below $55 give plenty of room for profitable trading, and it is reasonable to conclude that only a significant event will drive us through either level, in which case there would be a great deal of momentum to such a move. That sets up a classic range trading protective trade, where stop loss orders are for double position size to reverse the position if either level breaks. The momentum that would probably follow such a break should allow for recovery of losses, and possibly even turning a losing trade into a winner.
The phrase “stuck in a range” sounds like a negative thing for traders, but when it is clearly defined and actionable that is far from the truth. It is therefore with great pleasure that I say that oil is stuck in a range, and long may it stay that way!