The price of crude oil has made quite a comeback in 2019. After falling from a high at $76.90 per barrel on the nearby NYMEX futures contract on October 3, the price plunged to a low at $42.36 on December 24 which turned out to be a bottom for the energy commodity. Crude oil fell to within 21 cents of the June 2017 low before turning higher. The most recent peak was at $57.88 per barrel on March 1, and on Monday, March 4, the price settled at $56.59 per barrel a little over $1 below the recent high.
Crude oil exhibited strength on March 1 and 4 in the face of selling in other commodities and the stock market on the first Monday in March. The path of least resistance in the crude oil futures market has been higher since late December. Since mid-February, the energy commodity has traded in a narrow range between $54.52 and $57.88 per barrel, despite Friday’s selloff over fears that global economic weakness could weigh on the price of crude oil, the energy commodity continues to make strides on the upside.
The VanEck Vectors Oil Services ETF product (OIH) holds some of the leading oil-related companies in the world. The ETF dropped to a low at $13.13 per share in late December but it was trading at the $16.08 level on March 8.
Steady in a sea of dips
On Friday, March 1 the prices of gold and silver fell sharply. By March 5, silver had already reached a new low for 2019 and gold traded just 50 cents above its bottom level for this year. Copper backed off from its high at just under $2.98 per pound, and the dollar has been edging higher and moved above the 97 level on the March dollar index futures contract. Meanwhile, last week, stocks pulled back and time will tell if the equity market is preparing for another corrective move. A settlement below the 2775 level on the E-Mini S&P 500 futures contract on March 8 would result in the bearish reversal on the weekly chart since the first week of October, and we all know where that took the price of stocks during the final three months of 2018. The E-Mini was well below that level on Friday which could mean we are in for a rocky road in the stock market over the coming days and weeks.
Meanwhile, the price of crude oil has been hanging in there at around the $55 per barrel level, not far off its recent high.
As the weekly chart of WTI crude oil illustrates, the price has been in a trading range between $54.52 and $57.88 per barrel since mid-February. The slow stochastic, a price momentum indicator, has risen into overbought territory, but it continues to display a bullish price trend. Relative strength is at just under 50 which is a neutral reading. Weekly historical volatility dropped from over 47% at the start of 2019 to its current level at 29% which reflects the narrow trading range in the energy commodity. Open interest, the total number of open long and short positions in the NYMEX crude oil futures market has been steady around the 2.05 million contract level. The price of crude oil has been steady, and while last Friday was a day where the price dropped there are some signs that it will find a bottom not far from its current level at near $55 per barrel.
What is the term structure saying?
The term structure is the difference between the prices of crude oil for nearby versus deferred delivery. Term structure or the forward curve often provides clues about the supply and demand fundamentals for the energy commodity. Backwardation occurs when nearby prices are higher than deferred prices. Contango is a condition where nearby prices are lower than prices for crude oil for deferred delivery periods. When the oil market moves towards backwardation, it is often a sign of tightening supplies or strong demand. A move towards contango or widening spreads is often a clue that crude oil is either in equilibrium where supply is balanced versus demand or where the market is in a glut condition.
As the chart of April 2020 minus April 2019 NYMEX crude oil futures shows, the contango has been making lower highs since November which could be a sign of rising demand for the energy commodity as the contango has dropped from $4.44 to $1.84 per barrel. On March 7, the one-year Brent futures spread from May was trading at a small backwardation of $1.20 per barrel in a sign that production cuts and demand have tightened the crude oil benchmark that is the pricing mechanism for approximately two-thirds of the world’s crude oil supplies. The term structure is marginally supportive of the current price of the energy commodity and a continuation in the trend of narrower spreads would likely send the price of oil higher over the coming days and weeks.
Processing spreads are not bearish
Crack spreads represent the margin for processing a barrel of crude oil into oil products. When the demand for gasoline and distillate products rise, crack spreads move to the upside.
The daily chart of the NYMEX April gasoline crack spread shows that it has moved from a low at $12.10 at the end of January to over $19 per barrel as of March 8. While gasoline processing spreads tend to rally at the end of the winter season in anticipation of the driving season which is the time of the year of peak demand, a higher gasoline crack spread translated into more demand for crude oil which is the primary ingredient in the production of the fuel.
The heating oil crack spread is a proxy for other distillate products like diesel and jet fuels. The distillates have less seasonality than gasoline, so they are likely a better barometer of the overall demand for crude oil at this time of the year.
As the chart of the NYMEX April heating oil crack spread shows, the refining margin rose from $22.94 per barrel in late December to its current level at around $27.50 per barrel. The rise in the distillate refining margin shows that even though the price of crude oil rose over the period, distillate fuels outperformed the raw energy commodity which is a sign of strong demand. Therefore, both gasoline and distillate refining spreads support the gains in the price of crude oil and could be telling us that the energy commodity is on course for even higher prices over the coming days and weeks.
Brent-WTI is steady
The Brent-WTI spread tells us many things about the fundamentals of the crude oil market. The Brent premium reflects rising production in the US from the shale regions and OPEC production cuts. Additionally, since Brent is a favorable crude when it comes to the production of distillate products because of its higher sulfur content, strength in Brent can be a sign of demand for distillates. At the same time, WTI is the preferred crude oil for refining into gasoline because it is lighter and sweeter with lower sulfur content; the spread can also yield clues above gasoline demand.
Moreover, since more than half of the world’s crude oil reserves are in the Middle East, and Brent is the benchmark for that production, Brent-WTI is often a barometer for political risk in the world’s most turbulent region.
Since the Arab Spring in 2010 that brought sweeping political change across the Middle East, a higher Brent premium over WTI has been a bullish sign for the price of both Brent and WTI crude oil.
As the weekly chart of the price of WTI minus Brent displays, the Brent premium has made higher highs and higher lows since early 2016. The range has been between a $1.81 discount for Brent to an $11.55 premium. At the $9.18 per barrel premium for Brent on March 8, the spread between the two benchmarks is closer to the high and supportive of the price of crude oil based on its correlation with the price of the energy commodity since 2010.
OIH has lots of room on the upside
There are lots of oil-related companies that rise and fall with the price of crude oil. One of the most significant factors facing the crude oil market over the coming weeks and months is economic growth in the world’s most populous nation. A trade deal between the US and China could ignite economic growth in the Asian country that is home to 1.4 billion people and the second largest GDP on the earth. Economic growth will lead to an increase in the demand for energy and crude oil. Therefore, the oil market will be keeping a close eye on the progress of negotiations over the coming days and weeks.
The VanEck Vectors Oil Services ETF product holds shares in the leading oil services companies in the world. The most recent top holdings include:
Source: Yahoo Finance
OIH plunged with the price of crude oil over the final three months of last year.
As the chart shows, OIH has traded in a range from $13.13 to $76.25 since 2001. The low came in late December 2018, and since then OIH has recovered to over the $16 level which is a lot closer to the lows than the highs over the period.
A continuation of stability or higher prices in the price of oil will support gains in the prices of shares of oil services companies. OIH is an ETF that diversifies risk in the sector and could have lots of upside potential over the coming weeks and months. OIH has a yield of 1.75% since many of the companies it holds pay dividends. I would not be surprised to see this ETF recover to the $20-$30 level by the end of 2019.
Crude oil was sitting at over $55 per barrel at the end of last week. The price action in the energy commodity could be a sign that it will continue to make higher highs which would likely support gains in the OIH ETF product. Further weakness in stocks could weigh on OIH, but I would view a decline as a buying opportunity.
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