Is The Bounce In Oil Prices Sustainable?

This week, after falling since the end of April, oil futures officially entered bear market territory. That happened on Wednesday, with an unexpected build in inventories sparking the latest drop in crude. Despite that build though, the market bounced back yesterday. That raises the question, is this bounce sustainable?

There are essentially two ways of analyzing any market, technical and fundamental, and in this case, both give the same answer…no.

From a technical perspective, if we track this move down from the May 20th high of 63.96, this small move up looks like the fourth wave in a classic, five-wave Elliott pattern. That would mean that there is another, bigger downward leg to come that would take crude to the mid-forties.

Of course, technical analysis should always be done with the awareness that fundamental conditions will supersede any signal it gives, but the fundamental outlook now isn't any more encouraging. The trade war continues to escalate and, while the U.S. stock market can remain relatively strong, that escalation will continue to put pressure on the more globally focused oil market.

Encouraged by continued growth and no major drop off in economic data, President Trump has escalated the use of tariffs as a way of putting pressure on other countries to change their behavior. He sees them as a useful weapon and, most importantly, one without political cost. If anything, his base likes the idea of punishing other countries. So far, it looks as if that is being done with very little damage to the American economy, but the problem is that, like with all policy measures, the effects of tariffs are delayed.

It may be true that initially, exporters will bear the costs, but over time those costs get passed up the supply chain and have two effects. They squeeze margins on every company involved, reducing hiring and investment, and eventually they raise prices for consumers, dampening spending and confidence. Even if those effects are felt less in the U.S. than in the targeted countries though, a growth-dependent commodity such as crude is bound to suffer.

On the supply side, things look a bit better for oil prices. The Saudi oil minister has hinted at an extension to the OPEC+ deal to limit output, which is part of the reason for oil's bounce, but there are two things to consider here. The first is that this drop is primarily about demand and maintaining supply at current levels, as Khalid al-Falih has said he wants to do, will not address that slowdown when it comes. The second is that, as powerful as the OPEC+ group is, North American producers have already shown that the can and will bump up output to offset their efforts at supply restriction.

It is possible that Trump will reverse course on trade, or that China and/or Mexico will give in and make the required changes. Even if neither of those things actually occur, there are bound to be stories suggesting they will that will spark a short rally. Each time there has been a hint of a deal on trade so far though, while it has prompted a positive reaction in both stocks and oil, those bounces have been short-lived.

Given the bearish technical outlook and the fact that even if a deal is reached the negative effects of the tariffs already imposed will start to show in the data over the next few months, traders and investors should work on the assumption that this bounce, like the last few on the way down, is not sustainable and unless something changes a challenge of the January low is on the cards.