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Crude on slippery slope as supply concerns intensify

by Fawad Razaqzada

As we reported the possibility last week, oil prices have absolutely plunged in recent days. On Monday alone, Brent dropped by more than 6% while WTI shed almost 8%. The vicious sell-off has been driven by a number of factors, not least the technical breakdown that resulted at the end of last week when Brent took out key support at $61.30 and WTI $56.50. The sell-off in WTI has been more pounced. That’s because the destocking in US crude oil inventories ended after eight weeks and the rig count increased for the first time in several months, both raising concerns that the supply surplus is here to stay for the long run.

But the main reason why prices have fallen this dramatically in my view is because of optimism that a nuclear deal with Iran will be reached soon which would allowed it to eventually add up to 1 million barrels of oil per day in the already-saturated market. That would be significant, make no mistake about it. One has to wonder how this potential increase in supply will be accommodated for as after all the other OPEC members are in no mood to lose further market share, not only to Iran but also to US shale producers. The latest news regarding Iran is that the talks are still on-going, but the self-imposed deadline will be extended again by "couple of days", according to the European Union foreign policy chief Federica Mogherini. If sanctions are eventually lifted, Iran will probably not care much about the recent falls in oil prices; they will try to sell as much of the stuff as possible like all the other OPEC members for if they don’t they will lose out.

On the demand side, so much attention has been wrongly attributed to Greece. The fact of the matter is that besides Greece being a beautiful country, it is a small nation who will continue to use oil whether in or out of the Eurozone. The elephant in the room is actually China. Oil speculators are spooked by the weakening of macroeconomic data in the world’s second largest oil consumer nation. The recent stock market turmoil there underscores this view. If demand from China were to fall at the time the world oil supply is increasing then it could only mean one thing: downward adjustment in prices.

As mentioned, both contracts have been hammered after the technical breakdown that resulted at the end of last week. That breakdown probably caused oil bulls, worried about another leg lower in prices, to rush for the exits. Up until a few weeks ago, net long positions from hedge funds and other money managers in Brent had reached a record level and they were extremely high in WTI too, according to data from the ICE and CFTC. As this group of market participants have been proven wrong, they are likely to have covered those positions en masse. At the same time, oil bears, smelling blood, have absolutely mauled the bulls. They have been encouraged to come into play after the recent consolidation ended with price breaking lower.

The important question is where do we go from here? Although admittedly the sell-off is beginning to look a little bit over-done in the near-term, that’s not to say prices cannot fall further over time. Such sharp price moves typically reach at least their 61.8% Fibonacci levels. But given that the rally from March failed to even achieve a relatively-shallow 38.2% retracement in the downtrend from last year’s slump, I wouldn’t be surprised if prices fell back to their March lows or indeed even break below them. Still, the importance of the 61.8% Fibonacci levels should be underestimated, especially as in the case of WTI it is at around the psychologically-important $50 handle. On Brent, the corresponding Fibonacci level is around $54.50, which is just below the psychological $55 handle. Around these levels we may see some profit-taking, which could provide some short-term support for prices. The broken supports could now turn into resistance upon re-test.

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