3 Reasons Why Oil Prices Haven't Bottomed

by Cam Hui, Humble Student of the Markets

As oil prices have begun to stabilize, there has been a lot of opinions as to whether oil has bottomed or not. I thought that I would throw in my 2c worth on why I believe the path of least resistance for oil is still down.

Technical: Bottoms are a process

First, I refer to the excellent technical work done by Urban Carmel, who indicated that when oil prices crater the way they do, they generally don't form a V-shaped bottom:

Let's look at other drops in oil over the past 30 years. Below is a monthly chart of crude oil (WTIC). The yellow bars are the size and duration as the current fall in oil since June 2014. Three other instances look similar in that the drop was swift and without a pause (marked with stars: 1986, 1990 and 2008). Two others took twice to four times as long to unfold (1997 and 2000).

He pointed out that bottoms tend to be a process. If the recent rally is the first phase of a bottom, then rallies are typically capped by the 50 day moving average. Prices then weaken and then re-test the previous low, sometimes successfully and at other times undercut the low. The key feature of a bottom is a positive MACD divergence.

Still too much supply

Another impediment to a sustainable rally has been the dynamics of the futures market. Consider the forward curve of oil as shown below (via Yahoo finance):

The most often quoted price is the front month, which closed at 49.45. If you look out six months, however, the price is 56.43 and the 12 month price is 60.01. This upward sloping contango means that any trader with storage could buy oil at 49.45 for delivery, hold it and then sell it in six months for 56.43 for a tidy 14.2% profit (less carrying costs). A 12-month buy-and-hold will get you 21%.

The contango has created two effects. First, oil producers typically hedge their production with a 6 or 12 month strip contract (e.g. 12 month strip = 1/12 of 1st month + 1/12 of next month + ... ). The actual realized hedged price is about 10% higher than the often quoted front month contract. In that sense, things aren't as bad as the headlines sound.

In addition, the strongly upward sloping forward curve has encouraged trading desks and hedge funds to take advantage of the contango by buying the physical, storing it and selling it forward. Add a bit of leverage to that trade and you have yourself a very big payday. The contango has therefore created an inventory level that's off the charts (via Business Insider):

More Nigerian supply?

In addition, global supply could see a boost in the short-term. CNBC interviewed Helima Croft of RBC, who said that more geopolitical considerations could be at play (emphasis added):

Croft added other factors could also cause oil prices to bottom. "[Those] are not based on actual production," she said. "Those are more geopolitical factors." Croft also said some of these external geopolitical factors have yet to filter through the oil market.

"There's not a concern in the market right now about Nigeria," she said. "Their election was supposed to take place this weekend; it's been postponed.

Historically, we've seen significant volumes of crude come off the market around Nigerian elections

. In the 2003 elections ... we lost 850,000 barrels of production because of unrest around oil facilities."

Bottom line:

Don't expect the current oil rally to be long lasting or sustainable. I have no idea whether the mid-40s level seen in the most recent swoon was THE BOTTOM for oil prices, but my inkling is that the near-term direction for oil is down.

Copyright © Humble Student of the Markets

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