Deep Earth Publishing Newsletter, April 9th

Will Crude Collapse Again?

Last week, as optimism about a big cut in oil production was running high, I urged caution. Donald Trump’s announcement of an agreement and attempt to take some credit for it seemed premature, I said, and quite possibly reduced the chances of an agreement, or at least an effective one.

I was right…sort of.

Crude’s Wild Ride

Crude continued to trade higher on Friday, hitting 29.13 at the end of the day. Then, when it became clear that the promised meeting of OPEC+ for Monday would be delayed, it lost ground on Monday and Tuesday. Yesterday (Wednesday) rumors started to circulate that as much as 20 million barrels a day, twice what was originally thought, could be cut, and oil gained ground again…

Then reality hit. This afternoon we learned that the cuts would be the originally touted 10 million barrels a day and the futures contract, CL, dropped around 20% from its intraday high.

The 5-Day, 5-Minute chart for all that looks like this…

If you were following all that, either in real time or just by reading the above, you are probably a bit dazed and confused, so let’s look at what happened, why, and what we can expect from here.

What Happened

Basically, what we have seen over the last week is a giant buy the rumor, sell the fact pattern.

The first rumor was prompted by the Trump press conference, when he said that an agreement had been reached. Clearly at that point, it hadn’t. The Russians and Saudis, the two main players in all this had, it now seems, agreed to meet and discuss cuts, but no actual deal had been thrashed out.

The belief last week that a quick deal was coming coincided with a retracement in the stock market, as traders there started to work on the assumption that the effects of the shutdown to combat the coronavirus, while bad, probably wouldn’t be as bad as the worst case scenario markets were pricing in. That general air of optimism passed over to the oil market where “less disastrous than it could have been” seemed pretty good when combined with output cuts from some major producers.

When the cuts came earlier today, though, it quickly became clear that traders thought they may be too little, too late.

10 million barrels of oil a day sounds like a big reduction in global supply, until you realize that most analysts are estimating the effects of the coronavirus-related lockdown as around 30 million barrels a day. Prior to that, supply and demand had pretty much been in balance, with U.S. shale producers increasing output to just about offset the earlier OPEC+ cuts.

That means that there has been somewhere around a 30 million barrel a day glut for a couple of weeks, leaving a huge backlog of supply. To be honest, we don’t yet have exact data, so that could be an exaggerated number, but then it could also be an underestimation. Even if the real number is, say, a 20 million barrel a day glut though, cutting 10 million barrels won’t rectify the situation.

Little wonder that crude gave back so much ground today.

What Next

Ah, the age-old question for traders everywhere!

The obvious conclusion from all this is that crude is headed lower. In the short term, that is probably right, but I’m not in “$10 here we come!” camp for a couple of reasons.

First, it is important to remember that markets are forward discounting mechanisms, which is a fancy way of saying that they try to anticipate market conditions. From its pre-coronavirus high to the low three weeks ago, crude lost around 70% of its value. That prices in an awful lot of bad news.

Second, stocks around the world have continued to rally this week, on data showing that social distancing and other virus containment measures are having an effect. China, the world’s largest oil consumer, is gradually returning to work, and the modelled forecast for deaths in the U.S. has now been revised lower twice.

In other words, there is an economic disaster priced into oil that may not turn out to be as bad as feared.

Still, the disappointment over the size of the output cuts after such extravagant rumors makes a test of the lows likely over the next couple of trading days. However, at seventy percent below the recent highs and with a realistic hope that this will be a short, sharp shock to demand rather than a drawn-out crisis, that dip looks more like a buying opportunity than anything.

What to Buy

If you do use short-term weakness to buy, what should you be looking at? I still believe, as I have been saying for a couple of weeks that this is a time to prioritize size and stability over opportunity.

It is quite possible that some of the smaller names that have been hit so hard will show good short-term gains, but it is unlikely they will last, and the downside in those companies includes a not insignificant risk of total loss. There will be opportunities, but stock selection and timing will be key. The timing and space constraints of this newsletter don’t allow me to get into that, but we are thinking of launching a service soon that is better suited to that style of trading. If that would interest you, keep an eye on your inbox!

In the longer-term though, with the size of the glut already built up, oil probably won’t bounce back up above $40, let alone the $50 or $60 that some of these companies need for profitability for some time. More bankruptcies are coming among the smaller firms, so they are best avoided for swing trades or long-term investments.

However, if I am right, and we go no lower than the high teens in terms of WTI prices over the next few days, it will be a good time to initiate, or add to, long positions of the big, integrated multinationals.

Oh, and taking advantage of yields that would look good in an ultra-low interest rate environment even if dividends are cut in some cases isn’t a bad idea either!

Happy Easter, Passover or Ramadan to you all!

Cheers,

M

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