It's Been a Nice Run, but Oil and Energy Are Due for a Correction

Crude oil futures are pushing $70.00 per barrel a mere year after seeing prices dip well below $20.00. This is an impressive feat by any account.

While the market doesn't become obscenely overbought until we see $75.00 to $77.00, it is fair to say traders are likely getting over their skis. In our view, the downside risks likely dwarf the upside potential from here. The market has priced in full recovery to pre-Covid demand levels with supply likely to come back online.

U.S. shale producers have been reluctant to expand due to pressures to transition toward renewable energy sources and political uncertainty but supply always comes in commodities when prices are high. Further, $3.00 natural gas has been justified by hotter-than-normal weather forecasts, but weather is generally temporary. Even the unfathomable winter storms that caused Texas to freeze over and local natural gas prices to soar hundreds or thousands of percentage points wasn't enough to cause natural gas to hold over $3.00 per MMBtu.

We know we have been beating a dead horse regarding the U.S. dollar, but the reality is without the greenback weakness we have witnessed over the last 10 to 12 months the bombastic commodity rallies seen in energies, grains, softs, and others would not have been possible. I am not saying commodities wouldn't have experienced price increases, but I do believe those price increases have been exaggerated by favorable currency market fluctuations (weaker dollar).

Dollar bulls are few and far between, but when "everyone" is expecting the market to do the same thing we have to expect the opposite.

The dollar has been trolling multi-year lows for several months but that won't last forever. Either the greenback will melt down into the previous trading range between 70.00 and 90.00, or it rallies back into the current trading range between 90.00 and 105.00. As you have likely inferred, we are leaning toward the latter, a rally into the mid-90.00s appears to be highly probable with an eventual return to 100.00 plus is a real possibility. Even if there aren't any changes on the supply or demand front in oil, natural gas, or any other commodity, the change in currency valuation will be a significant drag on pricing.

Source: QST

We noticed bullish speculators have grown comfortable and rather aggressively long in oil. As of the latest COT report (Commitments of Traders) by the CFTC (Commodity Futures Trading Commission), large speculators have amassed a net long position of roughly half a million contracts.

In the past, we have seen net long holdings reach moderately higher levels (the all-time high record was 700,000 plus in 2018), but we have never seen a bull run survive such a large holding. This is because if the large speculators, those assumed to have deep pockets and are trading jumbo-sized positions, have already expressed their opinion by going long oil futures or constructing net long positions with options, the buying power could be mostly spent. In summary, if the majority of market participants are already long who is left to buy?

Source: QST

Looking at the weekly chart of oil, we can see the market is most comfortable at a price somewhere between $42.00 and $65.00. Since the late-2014 selloff in oil, prices haven't been able to hold above $65.00 or below $42.00 for the long haul.

We have also noticed that recent highs in crude oil involved a lengthy process of putting in a sort of triple-top where the market makes three spikes high in the span of two or three months but once the trend reverses the fallout has been stunning.

In late 2018, WTI crude oil topped near $76.00 to collapse into the low-$40.00s. In early 2020, a $65.00 spike high gave way to a plunge under $20.00!

Source: QST

In natural gas, the comfort zone has been between $2.50 and $3.50 mmbtu, however, in 2021 any rally over $3.00 has quickly reversed. Natural gas is far from a level considered expensive, but the path of least resistance is likely lower. Thus, we believe traders should focus on keeping upside risk minimal but keep the door open to downside exposure.

For instance, buying cheap puts might be the optimal way to get involved. As we have seen, railed rallies can see sharp drops in this market. On the flip side, you don't want to be caught short naked calls or futures. On occasion, this market can ruin the trading accounts (and perhaps the lives) of complacent bears.

Source: QST

Bottom Line

The energy rallies likely won't be able to survive a stronger dollar (if it happens as we believe it eventually will) but even without interference from the currency market, the current rallies are likely nearing an inflection point.

At the time of publication, Graner had no positions in any securities mentioned.

*There is a substantial risk of loss in trading commodity futures and options.