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Jim Hyerczyk

Jim Hyerczyk

Fundamental and technical analyst with 30 years experience.

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Too Many Longs Spoil The Breakout

March West Texas Intermediate crude oil ended January with a whimper, but showed promise early February with a spike to the upside, but this attempted breakout fizzled before it could gain traction. Once again buyers were thwarted by one of the key factors controlling the price action – too much U.S. supply.

To recap last month’s trading activity, two themes controlled the price action – compliance with the OPEC/Non-OPEC plan to cut output and increasing U.S. production. Based on the lower monthly close, it looks as if increasing U.S. production was the main concern. Based on the early price action in February, this theme seems to have been carried over into the next month.

In January, U.S. March West Texas Intermediate Crude Oil closed at $52.81, down $1.85 or -3.38%. International April Brent Crude Oil finished at $55.58, down $1.91 or -3.32%.

The March contract rallied to a multi-month high the first day of the month in anticipation of the OPEC production cuts, but that was it for the move. The rest of the month prices moved sideways to lower. In fact it took only six days to establish the market’s range for the month. After that, the market traded inside the range, swinging in both directions periodically. This type of price action typically indicates investor indecision and impending volatility.

On the bullish side, the month ended with Reuters reporting that crude oil supply from the 11 OPEC members with production targets averaged 30.01 million barrels per day (bpd) in January, versus 31.17 million in December.

OPEC also reported that the cartel achieved 82 percent compliance with its promised production cuts. This number exceeded market forecasts. Historians also point out that this number exceeded the initial 60 percent achieved when a similar deal was implemented in 2009.

Despite the stronger than expected compliance with the deal, both WTI and Brent crude oil have been capped by evidence of higher U.S. oil drilling and forecasts of an impending rebound in shale production.

According to the U.S. Energy Information Administration, U.S. oil production has risen by 6.3 percent since July last year to almost 9 million barrels per day.

Oil services company Baker Hughes also reported a surge in the number of producing rigs. On December 30, 2016, the number of active rigs stood at 525. As of January 27, the number was 566.

February Outlook

In February, crude oil investors will continue to focus on the same factors that drove the price action last month – compliance with OPEC’s deal to cut output and increasing U.S. production. Since compliance with the OPEC deal is expected to occur gradually as participants continue to increase their cuts, increased U.S. production should continue to have a bearish influence on prices.

However, if 1.8 million barrels per day are eventually cut then U.S. daily production would have to more than double to make up the difference.

Traders should also pay attention to developments between Iran and the U.S. that took place at the end of January since it could have a bullish influence on prices. Since Iran violated the nuclear trade agreement when it tested a ballistic missile, the U.S. could negate the deal and start sanctions. This would limit Iran’s production which could be bullish for prices.

As far as the Iran situation goes, traders are going to have to decide whether it will escalate into something major, or fade away if it turns out to be just a war of words.

Technical Analysis

Monthly March WTI Crude Oil

(Click to enlarge)

The main trend is up according to the monthly swing chart. The trend turned up in December when buyers took out the previous top at $53.86. The trend will turn down on a move through $43.42.

The short-term range is $35.59 to $56.24. Its 50% to 61.8% retracement zone is a support target.

The intermediate range is $65.70 to $35.59. Its retracement zone is $50.65 to $54.20. This zone is currently being tested. Trader reaction to this zone is likely to determine the longer-term direction of the market.

On the downside, one can see that taking out $50.65 with conviction could trigger an acceleration into the nearest support at $45.92. This would likely occur if the OPEC deal fell apart.

The price level controlling the market on the upside is $54.20. Traders have attempted to take out this level twice over the last two months. Each time, the move was met with renewed selling pressure.

The monthly chart shows that there is plenty of room to the upside if a rally over $54.20 can gain traction. This means big volume has to come in to support the rally. The market is near a record high in terms of open interest so it may be the lack of fresh buyers that is holding back the rally.

Typically, a market that is saturated with buyers has a hard time rallying. In order to attract new buying, the market may have to sell-off and the break has to be big enough to shake the tree and drive out the weaker longs.

It sounds counter-intuitive, but in order to move higher, crude oil is going to have to break sharply first in my opinion. Just looking at the chart, I think some of the weaker longs would panic if $50.65 is violated. They would likely exit their positions in droves. However, to the long-term investors, this would probably be a good buying opportunity.

In February, the price action inside $50.65 to $54.20 is likely to dominate the trade. Bullish traders are going to have to decide whether to buy strength over $56.24, or wait for a pullback under $50.65. It all depends on whether you’re a momentum or value trader.

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