Is a perfect storm brewing for higher Oil prices?

Summary:

• Crude oil moves up to highest level since November

• Weaker USD, risk-on flows and falling supply all playing a role

• Technical setup points to significant upside potential

There’s been a nice move higher in the price of crude oil over the last month or so, with the market recovering strongly after hitting its lowest level in 18 months around Christmas. In this analysis we will focus on some of the fundamental reasons behind this recovery, and also some which suggest that the market could go much higher, as well as discussing the latest technical situation for the market.

Oil and Oil.WTI

Before going any further it is worth pointing out that XTB offer two markets for crude oil, one based on the Brent crude futures contract (Oil on xStation) and one based on West Texas Intermediate (Oil.WTI on xStation). Brent is seen as an international benchmark whereas WTI is more US focused. In practice there’s little difference between them in terms of correlation, with good news for one market similarly good for the other and vice versa for bad news.   

Fed policy U-turn provides a boost

There’s often a fairly good long term correlation between the oil and stocks markets, with risk sentiment a prime driver of both. Both these have received a helping hand from the Federal Reserve of late, after the US central bank performed a pretty dramatic U-turn and seemingly changed the course of their monetary policy. After Chairman Powell spooked the markets in mid December by hiking rates once more and suggesting that the balance sheet run-off, also known as quantitative tightening (QT), was on a preset course he has seemingly changed tack. A speech at the start of January strongly hinted a more dovish approach going forward and this was confirmed after the recent meeting, with the Fed announcing that they were now “patient” on further rate hikes and considering altering the QT process.

Weaker USD and rallying stocks = good news for Oil bulls

This news provided a big boost to risk assets, with stocks soaring higher and crushed the US dollar which combined together has given Oil a dual boost. Due to Oil being priced in the US dollar, the market has an inverse correlation to the greenback, meaning a depreciation of the buck is a boon for the price of crude. While the current position of the Fed could change quickly, so long as they remain in a dovish mood that spells good news for the price of crude oil.

Oil and the USDIDX have shown a fairly strong inverse correlation (note the USDIDX price is inverted on the RHS). A rise in the USDIDX, shown by a decline in the blue line above, weighed on the Oil price during the last quarter of 2018. The recent drop in the USDIDX could be seen to suggest higher oil price. Source: xStation      

OPEC cuts support the recovery

The fundamental backdrop for the oil markets has become far more favorable in the past couple of months, with several developments supporting higher prices. The seeds of the recovery were actually sewn before the market bottomed out over the festive period, with OPEC announcing at the start of December that they would restrict production once more in an attempt to stabilise the markets - in other words push prices higher. Recent data has shown that OPEC pumped 30.98 million barrels per day (bpd) this month, 890,000 bpd lower than December and the largest month-on-month drop since January 2017 and this will no doubt aid the recovery in the market.

Supply disruption ahead from Iran/Venezuela?    

While the reduction from OPEC will no doubt help to support the oil price, unexpected supply disruptions have the potential for a greater positive impact and could cause a sharp move higher. Before the major sell-off in the last quarter of 2018, the oil price had rallied up to its highest level in over 3 years on fears of a disruption of Iranian supply following the reimposition of US sanctions on Tehran. These fears were ultimately misplaced when the US granted waivers for crude exports, and the aversion of this potential supply shock was arguably the single greatest catalyst for the subsequent price crash.

US enters fraught Venezuelan political situation

The situation in Iran remains tense and is well worth keeping a close eye on, but the more pressing concern at the minute is Venezuela. Last Wednesday (23rd January) the Trump administration announced it would back the Venezuelan National Assembly leader Juan Guaido, who declared himself the country’s interim president earlier that day. This sudden move could escalate long-running tensions between the US and Venezuela and have a significant impact on the oil market, where the Bolivarian Republic remains an important player despite its plunging output.  

Sanctions to be imposed?

In an apparent suggestion of U.S. military action, as well as further targeted sanctions against Caracas, President Donald Trump has said “all options are on the table”  and this could well see an even bigger drop than the expected decline of between 300,000-500,000 bpd in 2019. The U.S. has five oil refineries on the Gulf coast that are “heavily reliant” on Venezuelan crude to the tune of about 500,000 barrels per day and if sanctions are imposed then they would have to look elsewhere for their product.

Technical overview points to sizable upside potential

The recent gains in the WTI market, have seen price break above a potentially key resistance level at 54.50 and in doing so trigger an inverse head and shoulders setup. This reversal formation takes its head from the low of 42.60 seen back in December and if it plays out in a textbook fashion would target a symmetrical move above the neckline to 66.40. (The calculation is 54.50 - 42.60 = 11.90. 54.50 + 11.90 = 66.40). The prior resistance around 54.50 could now be seen as key support and as long as the market doesn’t end the day back below 54.50 then the breakout remains valid. The 8 and 21 EMAs are also in a positive orientation, 8 above 21, and indicative of a near term uptrend. Note how the bearish cross back in October preceded the major declines.   

In breaking above 54.50 the market has broken the neckline in a potential inverse head and shoulders formation. This would target a significant move higher and remains valid while price trades above 54.50. Source: xStation