I spend a lot of time these days studying oil. From a trading perspective it is one of the best markets around, or at least for me. Futures provide highly leveraged, readily available, and relatively inexpensive access to a market that responds to the kind of mix between fundamental and technical factors that I am familiar with given my interbank forex background. Those factors, including the two-way movement of volatility, are ever-present, but every now and again oil sustains a move long enough to grab the attention of the mainstream financial media. That is what we are beginning to see now, and long before we are likely to get the usual rush of hyperbolic forecasts and predictions. Some of those will sound immensely scary, so investors should understand the reasons for them and why they should ignore them now, before they flood the airwaves and internet.
As usual when something hits the headlines, most of the commentary is along the lines of “How far can we go?”, whether that is up or down. In this case it is up. Both WTI and Brent crude are trading at multi-year highs, prompting a round of predictions from analysts of both the Wall Street and media varieties that consists of increasingly high forecasts for oil prices. Those that were predicting $80 per barrel for WTI when we broke $60 at the end of last year are now saying $100 is reachable, with many more behind them looking at $90.
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Markets are unpredictable by nature, so of course there is a chance they could be right, but the ever-increasing forecasts often seem to be more about attention grabbing than any real analysis. Positing the most likely scenario, that oil will slow its rise after climbing around 70% in less than a year, will not, after all, get you on T.V. If, however, you predict that oil will jump to $120 and that that will precipitate a massive recession and a collapse in the stock market you will be welcome at every media outlet looking for eyeballs and clicks. It is easy to get caught up in the fear and sensationalism when you hear it from every angle, but when you understand the dynamic that drives it, that is less likely.
In this case, it is quite likely that oil will continue to move a little higher from here. Futures have been climbing steadily since the end of June last year, but from a chart-reading perspective the ordered nature of the climb, with several phases of consolidation, make that look like a sustainable move. Fundamental analysis also suggests that we are not done moving up yet.
The three main drivers of oil during that time have been the output cut agreement between OPEC and other significant producers announced in September of 2016, an improvement in prospects for global growth, and increased tension in the Middle East. All those things are still in place and can be expected to continue, if only for a short time. Even moderating influences have not proven as influential as predicted. The increase in U.S. shale production that was expected to offset the bullish influences has materialized, but it has been absorbed by the market and prices have kept on climbing. At some point, however, the laws of supply and demand will take over.
At that point, those high prices will be their own worst enemy. Adam Smith’s “invisible hand” will take over as supply increases and/or demand reductions put a cap on prices and force a turnaround. What the sensationalists would have you believe is that that point will only come when we hit crisis levels, but history and common sense both suggest that will not be the case.
The three drivers of higher oil prices identified above may still be in place, but they all have an endpoint.
The Saudis, the most ambitious of the production cut agreement’s signatories, say that oil around $80 would suffice for them and Brent hit that level yesterday. Increased global growth has continued, but with the Fed moving to raise rates a little more aggressively and the effects of that growth being largely priced in, upward pressure from growth will be limited from here. Middle East tension represents more of a threat. Trump’s unilateral abandonment of the Iran deal and decision to relocate the U.S. embassy in Israel to Jerusalem haven’t helped in that regard. In the short term that will keep a bullish tone to oil, but it is not like Middle East unrest is a new thing for oil traders. All in all, it looks like the bullish influences are still around but fading.
The logical conclusion therefore is that oil prices could move a little higher but will stop and turn before long. As the effects of the abandonment of the Iran deal are felt, we may see WTI as high as $75 or maybe even $80, but that is likely to mark the top. When the increasingly hysterical calls for $100 and resulting doom and gloom come, traders and investors should understand the nature of those calls and ignore them. In the unlikely event that they turn out to be true there will be plenty of time to adjust but panicking early makes no sense.