Demand worries weighing on crude oil

Third quarter strength continues to deflate with production cuts from Russia and not least Saudi Arabia beginning to have the opposite than intended impact on prices. From late June to late September Brent crude oil rallied by around one-third in response to Saudi production cuts amid a quest for higher prices and OPEC estimates of a 3 million barrel a day supply deficit. 

Fast forward and despite the biggest threat to Middle East stability in years, and production cuts being extended to yearend, crude oil prices have reversed sharply lower, once again highlighting how producers can control supply but not demand which is now showing signs of weakening, as the economic outlook for Europe, and potentially also the US and China remain challenged. Rising energy prices during the past six months helped slow the drop in inflation while strengthening concerns central banks would be forced to adopt a high(er) for longer stance on rates. The latter helped drive a steep rise in bond yields which triggered stress signals from the wider economy as it pushed up mortgage rates, hurting borrowers while causing painful losses for many investment funds and banks that could, in turn, curb lending into the economy. It has also pushed up borrowing costs across the developed world in the process sucking money out of emerging markets.

From early July to late September managed money accounts, such as hedge funds and CTA’s jumped onto the tight-supply led rally, and during this time they increased their net long position in WTI and Brent crude oil futures by a total of 326,000 contracts or 326 million barrels to a two-year high at 560,000 contracts, on a combination of 184,000 contracts fresh longs and the gross short being cut by 142,000 contracts to a 12-year low at just 45,000 lots.

Do note that this group tends to anticipate, accelerate, and amplify price changes that have been set in motion by fundamentals, in this case the production cuts. Being followers of momentum, this strategy often sees this group of traders buy into strength and sell into weakness, meaning that they are often found holding the biggest long near the peak of a cycle or the biggest short position ahead of a through in the market. In this case they were left holding a major long position just as the demand outlook started to deteriorate, hence the risk of prices once again overshooting to the downside as funds adjust positions once again.

Having once again, just like early October broken the 50% retracement of the June to September rally at $84.63, Brent crude has extended its decline below $83.44 with indicators suggesting a move down to strong support around $82. An RSI below 40 supports the bearish picture.