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Cartel Curbs and Quotas: Cross Currents in Crude

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June 7, 2017
Crude Oil Currents
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Crude oil is hard to find because it doesn’t have the common decency to reside on the earth’s surface. To get to it you must drill down, sometimes miles down, underneath Arctic shelves, Saharan sands, and Dakotan shale. To understand the recent weakness in crude oil prices, we must also look below the surface to see what’s fundamentally affecting oil supply and demand.

Even though OPEC recently announced an agreement to prolong output curbs for at least another nine months, oil finished last week off 4%, near four-week lows. A falling US dollar, strong economic growth, and continued geopolitical unrest—normally bullish factors—have also failed to create a bid under crude. To find out why, let’s “drill down” a bit.

The OPEC announcement should seem like a catalyst for higher prices, as less production means lower supply, but not all member states are complying with the agreement. For example, some members such as Iraq have been known to ignore quotas, while Libya and Nigeria – both exempt from cuts due to sanctions and infrastructure sabotage – have increased their output by a combined 140,000 barrels per day, according to published reports.

In addition, there are doubts that Venezuela —which is in the middle of an economic meltdown and has the largest proven reserves in the world—can maintain the agreed-upon cuts for much longer.

The New (Big) Kid on the Block

Weighing even heavier on crude prices is the emergence of the United States as a major world producer. In 2007, 60% of America’s crude oil was imported, but that number has dropped dramatically and now hovers around 26%, according to data from the U.S. Energy Information Administration. Much of this change is due to technological advances, which have allowed producers to use new techniques like fracking to extract oil domestically.

Last week the market got data confirming this trend toward self-sufficiency. Plus, a presidential announcement has got many thinking it will continue.

On Friday, US driller Baker Hughes reported that the number of domestic oil and gas rigs increased for the twentieth straight week, to 916—double the number in operation a year ago when crude prices were higher. But perhaps even more bearish for oil prices was the announcement by President Trump that the United States would withdraw from the Paris Climate Accord, which sent futures contracts down more than 1% on Friday alone.

The thinking among many analysts is that the withdrawal signals a wider acceptance by the Trump Administration for allowing oil exploration and production in previously protected regions like Alaska and the California coastline. And if that comes to pass, U.S. oil production could expand more rapidly than it is currently, which could flood the market with even more cheap oil.

Let’s Go to the Charts

At first glance, oil’s movement—represented by crude oil futures (/CL)—has been uneventful, as it’s trading roughly where it started the year. But from a technical standpoint, things get a bit more interesting.

Crude Oil chart, 2 yr

FIGURE 1: TIGHTENING CHANNEL.

After a big fall in 2015 and early 2016, crude has been in an ever-tightening range for over a year. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

After falling precipitously in 2015 and early 2016, crude found a low in February, and rallied into a range. From there, price has moved sideways, slowly but steadily constricting in a narrowing range, with neither buyers nor sellers able to overpower the other for very long.

Currently, crude is trading in the lower end of this range and looks like it may test the bottom trendline. If that level is breached, it could very well move down and test the March lows. Conversely, a break to the upside may signal that demand is beginning to exceed supply and a new uptrend is starting.

The takeaway from both the fundamental and technical picture is that there’s no clear trend—up or down—and that this sideways movement could continue for some time, especially given that we are entering a traditionally slow period for markets. Plus, market volatility in general is at historical lows. This bears watching, as any move outside the channel, whether up or down, may set the tone for the second half of the year.

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