The Bull and Bear Case for Crude Oil

• Demand remains weak- The distillate crack sends a signal
• Significant production cuts were necessary to balance the market
• Commodity prices are leaning higher
• The global economic landscape points to inflationary pressures

Crude oil has been trading around its $40 pivot point on nearby NYMEX futures since early June. The price rose steadily from the April low, but ran out of upside steam at the $40 level and has spent the past months consolidating around that level.

In September, selling in the stock market and rising concerns over the global pandemic and US election caused the nearby NYMEX November crude oil futures contract to fall to a low of $36.58 on September 8. The price recovered back over $40, but last Tuesday, crude oil began to fall again. The price traded down to a low of $36.63 per barrel last week even though the dollar index was weakening.

The rising number of coronavirus and rising prospects for a second wave of infections sent a chill through the crude oil market. President Trump’s hospitalization on Friday, October 2 was another sign that the pandemic continues to be a clear and present danger.

The winter season is typically a time of the year when oil prices are susceptible to downside corrections. Moreover, memories of negative prices in April when demand evaporated were weighing on the price of the energy commodity. However, there are some constructive signs on the horizon when it comes to the price of the energy commodity.

Bullish and bearish factors are pulling crude oil in opposite directions. The United States Crude Oil Fund (USO) moves higher and lower with the price of the futures that trade on the NYMEX division of the CME.

Demand remains weak- The distillate crack sends a signal

Nearby crude oil futures on NYMEX closed the third quarter of the year at $40.22 per barrel. Window dressing at the end of a quarter tends to push prices in the direction where market participants hold risk positions.

Therefore, the end of the quarter is a time when the market often pulls back the curtain on consensus opinions. Last Friday, the November contract settled. At $37.05 per barrel.

One of the problems facing the crude oil market is weak demand. The distillate crack spread reflects the margin for refining a barrel of crude oil into heating oil, jet and diesel fuels, and other distillate products.

While gasoline is a seasonal oil product that tends to display strength in the spring and summer and weakness in the late fall and winter, distillates are more year-round products. The refining margin for distillate products at the end of last week continued to reflect the weak demand for oil products.

Source: CQG

The monthly chart of the heating oil crack spread, which is a proxy for distillate products, highlights that it was trading at the $8.55 per barrel level as of Friday, October 2.

In September, the processing margin traded to its lowest level in a decade since March 2010 at $6.44 per barrel. The last time it traded that low during September was in 2009. The range in the spread in September 2019 was between $21.09 and $26.10. In 2018, it traded between $22.48 and $25.94 per barrel.

At below $9 per barrel at the end of last week, the level of the distillate crack spreads tells us that the demand for crude oil and oil products remains under pressure as we move into a seasonally weak period of the year during the winter months.

Significant production cuts were necessary to balance the market

It took significant production declines in the United States and worldwide to lift the price of crude oil to the $40 per barrel level over the past months. OPEC, Russia, and other world producers have kept the level of quotas at a 7.7 million barrel per day output but since August.

The group tapered the cut from 9.7 mbpd after oil recovered to over $40 per barrel. Last Thursday, the Energy Information Administration said that daily output in the US stood at 10.7 mbpd, unchanged from the previous week, but 18.3% below the peak level in March.

The decline in production was a necessary event for supporting the price of crude oil so it could move back to the $40 level after the price carnage in March and April 2020.

Commodity prices are leaning higher

Meanwhile, commodity prices have been moving higher over the past weeks and months. Gold rose to a record high at over $2000 per ounce and was just above the $1900 level on October 2. Silver was trading at over $24 per ounce after reaching a peak just shy of $30 in early August.

Copper was near $3 after trading down to just above $2 in March. Last week, grain prices rallied. Lumber traded to an all-time high at $1,000 per 1,000 board feet in September.

Crude oil is one of the leading commodities as it continues to power the world. Despite the growth in alternative energy products and move away from hydrocarbons, crude oil continues to be the raw material that powers the world. The oil market faces a magnetic pull from the commodity asset class.

The global economic landscape points to inflationary pressures

The US dollar is the benchmark pricing mechanism for most commodities, and crude oil is no exception. The trend in the dollar versus other currencies has been lower since March.

Source: CQG

As the weekly chart illustrates, the dollar index futures contract fell from 103.96 in March to a low of 91.725 on September 1. The recovery to the 94 level leaves the dollar index a lot closer to the low than the high over the past six months.

At the beginning of October, the trend in the dollar remains lower. A weaker dollar tends to support all commodity prices.

Central banks worldwide continue to follow an unprecedented level of accommodative monetary policy. The economic impact of the global pandemic has required a tidal wave of liquidity. Short-term interest rates are at historic lows, and quantitative easing is keeping rates low further out along the yield curve. The US Fed told markets they are prepared to tolerate an inflation rate above 2% to stimulate economic conditions.

Governments continue to provide stimulus in the form of bailouts, enhanced unemployment benefits, and helicopter payments as fiscal policies to confront the coronavirus. With the number of cases rising again during what looks like a serious second wave, the stimulus is likely to continue to flow. After borrowing a record $3 trillion in May, the US Treasury will likely need to borrow more before the end of 2020.

Stimulus and liquidity increase the money supply, which is inflationary. Many commodity prices have moved higher over the past months in a sign that some inflationary winds could be blowing through the economy. Moreover, the period following the financial crisis in 2008 led to higher commodity prices, which peaked in 2011 and 2012.

The stimulus a dozen years ago and accommodative policies fuel the rally in raw material prices. Albert Einstein said that the definition of insanity is doing the same thing repeatedly and expecting a different result. With stimulus at even higher levels in 2020, commodity prices are likely to continue to move higher over the coming years.

Crude oil faces bullish and bearish factors, that pulls the energy commodity in opposite directions at the start of the final quarter of 2020. The distillate crack spread is a negative sign for the market. However, a secular bull market in commodities could be the most potent force the oil market faces over the coming years. Expect lots of two-way price volatility over the coming weeks.

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The United States Oil Fund (USO) was trading at $27.58 per share on Monday morning, up $1.23 (+4.67%). Year-to-date, USO has declined -73.09%, versus a 6.27% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of D (Sell), and is ranked #64 of 112 ETFs in the Commodity ETFs category.