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Crude oil surges then plunges… what now?

by Fawad Razaqzada

After making some strong gains over the past few trading sessions, crude oil bulls finally buckled under pressure as both contracts fell sharply on Tuesday along with equities on heightened fears about the health of the global economy. Demand concerns were initially raised by the latest manufacturing PMI data out of China overnight which contracted to a three-year low of 49.7. Most of the closely-watched sub-indices also fell below the expansion threshold of 50: new orders declined to 49.7, while new export orders dropped to 47.7. With the manufacturing PMI below 50.0 since July and having spent most of the year hovering around this level, it is clearly a worrying sign for the world’s second largest economy. On top of this, the latest manufacturing PMI readings out of the Eurozone, UK and US were all weaker than anticipated and this has further heightened demand concerns.

In fact, the health of the world’s largest economy will be in focus as we have several top-tier macroeconomic pointers from the US scheduled for release this week, culminating in Friday’s much-anticipated nonfarm payrolls data. If the current trend of weaker data continues then oil may struggle to regain any more ground than it already has. The focus will also be on the usual inventories data with the official stockpiles report due out on Wednesday afternoon. Although the US Energy Information Administration (EIA) reduced its estimates for US crude production in the first five months of the year, this was due to a change in the way it gathers its data (it now incorporates some numbers directly from companies, in addition to data from state agencies). So, it remains to be seen if the US crude surplus will be reduced meaningfully any time soon. Though the weekly change in oil stockpile levels since the start of the summer has generally been negative, the magnitude of the declines has been very modest. Given that we are now in the twilight of the summer driving season, gasoline demand is set to fall. The usual refinery maintenance works will further reduce demand. It is thus unlikely we will see further sharp declines in crude stockpile levels – unless many shale producers go out of business all of a sudden (an unlikely event). Therefore, even if oil manages to extend its rally from these levels, it is unlikely that we will see significantly higher prices for the foreseeable future.

That being said, the near-term technical picture for oil remains bullish despite this latest sell-off. It could be that a bottom has already been found and that Tuesday’s selling was merely due to profit-taking as both contracts found some resistance around their respective 50-day moving averages. After all, one cannot ignore how oil has rallied in recent trade – it has risen nearly 25 per cent in the space of three days alone, representing the strongest three-day jump since 1990 (when Iraq invaded Kuwait). Thus an equally sharp pullback was overdue anyway. Scared by the sudden jump in prices, some of the exiting sellers may now have the opportunity to exit their positions at better levels. Meanwhile those who missed the initial rally may now look to “buy the dip.”

If it was indeed profit-taking that caused the sell-off, oil will now need to hold its own above the key support levels that are now approaching/being tested; otherwise there is a risk we will be back to square one very soon. As can be seen from the chart, the psychologically-important level and previous resistance at $50.00 was being tested at the time of this writing. If Brent holds above here on a daily closing basis, then it may make a move towards the bearish trend line that has been in place since June last year, around $55.00. Then, depending on what happens there oil may either fall back or sharply extend its gains upon a potential breakout. Meanwhile if support at $50.00 breaks down then the bears may aim for the next support at $48.20 or even the all-important $45.00/20 handle as their next targets. Expect volatility to remain high (= lots of trading opportunities).

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