Should Traders Trust The Drop Or The Bounce Back In Oil?

It has been an interesting couple of days in oil futures. The commodity had its worst day for a while yesterday as traders reacted to Donald Trump’s tweet threatening an escalation in the trade war with China. This morning (Friday), however, oil is bouncing back, and at the time of writing has recovered around half of yesterday’s losses. So, which move should traders and investors trust, the drop or the bounce?

The pattern shown in the above chart for the futures contract, CL, is one that is familiar to stock traders. Ever since the 2016 election, stocks have shown a tendency to overreact to Trump’s tweets, then recover losses quite quickly.

There are numerous single-stock examples of this, from Boeing falling on an early tweet from then-President-elect Trump about Air Force One to reactions to more recent attacks on Amazon (AMZN) and other more generalized attacks and threats aimed at big tech companies. The broader stock market has also reacted in the same way when Trump has tweeted about trade. In those cases, too, the initial negative response has proved to be an overreaction, as evidenced by the fact that the major indices keep hitting new highs.

There are, however, several differences when it comes to oil. The first is that oil traders tend to take a longer-term, more global view than the stock market.

We frequently hear from stock traders and analysts that the strength in the U.S. economy allows America to “win” a trade war, taking less of a relative hit in the short term in pursuit of a long-term goal. There is some truth to that, but for oil, the relative argument is less persuasive. Any slowing of global demand is a bad thing for the commodity.

The second thing you often hear is that the impact of tariffs so far has been muted, so there is really nothing to worry about. That, however, ignores the fact that there is always some lag before the effects of policy show up in the numbers. For oil companies, who plan decades rather than months ahead, the lack of evidence of immediate damage is not necessarily a consolation.

The second big difference is that oil pricing is a function of supply as well as demand. There was mixed news on that front this week, as oil stocks fell for a seventh straight week, but U.S. production increased. The inventory decline suggests strong U.S. demand, but the rapid return to pre-Hurricane Barry output levels once again shows the ability of the U.S. to increase output quickly.

In any trade, the technical picture should also be considered, and that adds to the bear case.

The price action of the last couple of days confirms a bearish pattern of lower lows and lower highs, and suggests a fourth, downward wave of a classic Elliott Wave pattern is coming before long.

So, when we add everything up, while the initial drop was big enough to class as an overreaction to a tweet, it is the bounce back, not that move, that looks like it is unsustainable. On the bright side, there are some things that make a massive drop unlikely. The latest Trump tweet could prove to be a negotiating tactic that results in no real escalation of the trade war, and supply from the OPEC+ group is still restricted. For now, though, a drop back to test the lows looks far more likely than a full recovery.