As global markets have been rocked by volatility related turmoil, crude oil markets in the US have had their own shot of wild swings with a popular oil market volatility index soaring to multi month highs. This period, and its strong dose of unease, has seen lower prices in WTI crude, which naturally leads to speculation that the rally oil has experienced over the past month might have crested and could now be fading.
Looking ahead to next week, there are three dominant themes for traders to remain mindful of as the narrative builds that a further correction in oil prices might be coming. Each factor independently is an important consideration. Being wrapped together they form a unique combination of headwinds that could force a complete stall of the rally and a reversal to a lower price range.
Three themes for the oil market:
Rapidly shifting market sentiment and turmoil - Global markets have seen a return to volatility, with wild swings throughout the week. This action has leaked into oil markets and what had been relatively stable footing for oil traders just a week ago is now a rocky and uneven landscape.
Rapidly accelerating production and inventories - What was perceived as a tightening market that was moving into balance could now be quickly tilting to a state of over supply.
A strengthening US dollar - Talk of a weak dollar dominated markets in the first month of the year, but the dollar has rebounded in line with demonstrations of further strength in the domestic US economy.
Rapidly Shifting Market Sentiment
Through the first month of 2018, momentum returned to oil as price rose, and a bullish energy was injected into markets.
A healthy amount of that constructive support stemmed from a consistent cadence of positive news. However, the second month of the year has brought about a much different news flow and fundamental picture. Concerns about the mitigating measures central banks may take to tame potentially overheating economies introduced a level of volatility in equity markets that seemed to feed on itself until it reached a full on rage. That cycle rocked markets and exchanges globally, and has traders questioning their base line outlooks for the first quarter.
With the positive news dynamic we saw in January now gone, at least for the moment, and a cloudier overhang in place this week over market sentiment, a risk averse mood might be settling in, and that is rarely positive for crude oil prices.
WTI crude oil has seen a sharp increase in volatility recently, which has coincided with a developing weakness in price.
Rapidly accelerating production and inventories
A surprise was delivered this week related to oil inventories. The Energy Information Administration (EIA) reported an inventory build of 1.9 million barrels for the week ending February 2nd, which was not anticipated by markets. The bear market in oil in 2017 was marked by a supply glut, and indications that we could be headed back in that direction could certainly weight on forward prices.
This report came only a day after the EIA released projections indicating oil production in the United States could hit 11 million barrels per day in late 2018. Just last month, the EIA had expected that level to not be acheived until late 2019. Their expected average for the full year is now 10.6 million barrels per day, which is a marked increase over previous levels.
A strengthening US dollar
The United States dollar had been defined by a lengthy and protracted weakening that had influenced markets across the financial spectrum.
The dollar impacts oil by being the currency global oil markets are denominated in. When the dollar is weaker, oil importers can afford to buy more, and over lengthy periods of time there can be an inverse correlation between a lower dollar and higher oil prices.
With the US economy continuing to surge markets are expecting higher interest rates in the medium term to combat the potential for inflation. This narrative has been constructive for the value of the dollar.
The dollar is also widely seen as a “safe haven” asset, and during times of market turmoil, with more dollars in demand, values can lift. While the dollar has only seen a mild stabilization, and it remains to be seen if it will take off on a trajectory higher, this dynamic is certainly a potential issue for any further momentum in near term oil prices.
Outlook for next week
Even with the recent firming in dollar values, the greenback is still down for the year, meaning it still has considerable room to run higher. This should be a concern for bullish oil traders. A mild and incremental move higher for the dollar is a fair expectation for the short and medium term which could further dampen the picture for oil prices.
We also feel supply pressure will could continue to accelerate and exert potential downward pressure on the price of WTI crude. With forecasts changing weekly and monthly, it is still a very fluid situation. However, forecast revisions seem to be heading one way, and outrunning scenarios for potential upticks in demand.
It is challenging to guage broader market conditions over the short term, but it is fair to assume we will still journey through choppy waters, at least for the next week, given the recent corrective movement we have seen from record highs on most major equity indices.
All these factors build a rather bearish picture for oil prices.
Risks to this outlook could come from any major geo-political event that could impact oil supplies, a resumption of dollar weakness, or signs of an abrupt slowing of US production.
With conventional fundamentals turning so quickly against higher oil prices, it is our view it would take an major unforseen and low probability event over the near term to provide hope for an extension of the rally.