Headwinds Remain For Energy Markets
Mixed signals from the energy market
Despite a generally favourable start to the year for the stock market (last week’s SVB turbulence aside), energy markets have continued to trend sideways. Failing to catch a bid from the China reopening story that many believed would buoy oil prices and energy stocks higher, the bearish story from the oil inventories side of the equation coupled with continued recession fears has seemingly held energy markets down. Although the long-term supply constraints suggest oil is going much higher over time, short to medium-term headwinds remain and so does the potential for lower oil prices in the months ahead. Patience is still required for energy bulls.
As always, I analyse the energy and oil market through the lens of the physical market, fundamentals, sentiment/positioning, the macro-outlook, as well as technicals. Viewing the market through such a broad array of indicators helps to provide as clear and concise an outlook as possible for oil prices and energy stocks.
Inventories remain bearish
Beginning with a look into the physical market via the change in crude oil inventories, the picture has been mightily bearish since late-2022 and remains the case today. In assessing movements in inventory levels, we can obtain a decent proxy for real time supply and demand. The past few months have seen the largest inventory build since early 2020 (and we all know what happened then), leading to current inventory levels being well above their historical averages. Clearly, the supply and demand dynamics are bearish for now.
As such, these continued surplus inventory levels remain a headwind for oil prices. Given the fundamental insight into the oil markets provided by inventory changes, it will be difficult for prices to move materially higher until these forces abate.
However, we can glean some positivity from these dynamics. The fact that the inventory builds have been this bearish for a number of months now and yet crude has largely consolidated remains a positive development in my book, highlighting just how strong the structural supply shortages are within the market. Should these factors turn bullish, I do expect the price reaction to be material to the upside.
Crude oil term structure flirting with bullishness
While specific prices of the various futures contracts are themselves not useful predictors of future prices, the shape of the futures term structure does provide valuable information into the underlying fundamentals of the oil market, and is another excellent indicator of the status of the physical market. Generally:
Backwardation implies there is a supply deficit as market participants are willing to pay a premium for instant delivery. As a result, any deficit will need to be met via drawing down inventories.
Though backwardation incentivises drawdowns of oil inventories, it does not incentivise producers to increase production and capacity, as they would be forced to sell forward new production at a lower cost than today.
Over the past three to four months, the term structure has gone from a rather extreme level of backwardation that was present for much of 2021 and 2022, to fluctuating between backwardation and contango. Today, the term structure remains in backwardation, though the April-May time spread is still exhibiting contango, suggesting it is not a clear-cut sign of tightness.
While the overall backwardation is bullish as it clearly highlights the structural tightness of the oil market, the ideal scenario is to see these shorter-dated time spreads confirming the longer-dated spreads.
This is perhaps better illustrated below, where I have overlayed the spot oil price with the April-May and April-December spreads. Generally, should the shorter-dated spreads diverge from the spot price, it tends provide a decent signal as to the forthcoming price action. We saw this in the beginning of 2023 when the April-May spread diverged lower from the spot price, to which the spot price eventually followed lower.
Overall, the general level of backwardation present in the crude oil term structure continues to suggest a tight physical market.
Pessimism is rising
If we turn our attention to the sentiment and positioning dynamics within the oil market, we are seeing both nearing washout levels that tend to coincide with intermediate-term market bottoms.
Indeed, overall speculative positioning in the futures market is now at its lowest levels since 2016, whilst sentiment (proxied below via the $BPENER index) is also reaching levels indicative of extreme pessimism. Neither are a useful market timing tool, but both provide contrarian signals for long-term investors.
For a timelier signal, we can turn to the managed money category within the futures market. This is the CFTC’s category for hedge funds and CTA’s, whose flows are generally responsible for driving trends in price. Though the Commitment of Traders data has yet to be released for March, the most recent data shows managed money’s net positioning to be in relatively neutral territory. However, if you also factor in the managed money positioning in brent crude oil futures (not pictured) their positioning seems to be leaning toward the long-side, meaning there is potential for hedge funds and CTA’s to drive prices lower should they unwind these long positions. Watch this space.
The macro-outlook remains bearish
From a macro perspective, headwinds remain for the energy markets. Although oil is both demand and supply sensitive, either can win out in the short-term, and, should the leading indicators of the business cycle continue to suggest growth is set to deteriorate throughout 2023, then this will continue to weigh on demand.
So far, energy markets have done a fairly solid job of pricing in the growth slowdown. This is particularly so for the oil price, which unlike energy stocks, is not forward looking in its price and has effectively traded in-line with growth. However, my indicators have been suggesting for some time the ISM Manufacturing PMI is likely to bottom around the 35-45 area at some point this year, and if true, points to further potential downside for both energy stocks and the oil price itself.
How much of a floor the structural supply issues can put under prices remains to be seen, but the growth outlook is certainly a risk for oil markets over the coming months.
The technical picture
Price action continues to look interesting for the oil price. The $70 area seems to be the last area of support, and if broken, could usher in a fall to $60 in short order. Whether this eventuates or not remains to be seen (my bias is that it breaks), but the overall price action looks like it wants to go lower. Perhaps the market needs one final washout low before we see prices move higher.
Longer-term, we can see there is strong support around the $60-65 area, and if we do see prices move lower, this looks to be an excellent point to add long-term exposure.
In terms of seasonality, the second half of March tends to see fairly sideways price action for the oil price, though this is set to turn materially bullish as we enter the summer driving season in the northern hemisphere come April through June.
Meanwhile, energy stocks look to have just broken their long-term trend line that has defined this bull market since late 2020. Should energy stocks continue to correct, $110 for the XOP ETF appears the next major support area. Again, this would appear an attractive entry point for long-term investors.
In summary, we are seeing a number of mixed signals for the oil market. Inventories are sending particularly bearish readings, while the macro and technical picture both continue to deteriorate. Clearly, these dynamics suggest the potential for further downside is present, though not guaranteed.
I do believe a material rally in oil and energy prices is likely at some point during the next few years. While the bull market could resume at some point during the second half of 2023, the near-term outlook is far less constructive. Investors should be aware further downside is a possibility, particularly if we see economic fundamentals deteriorate as their leading indicators suggest they will. As such, energy bulls should remain patient and use any material market weakness to their advantage.
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