Oil Trading Alert originally sent to subscribers on January 14, 2015, 10:19 AM.

Trading position (short-term; our opinion): Short positions with a stop-loss order at $48.34 and an initial price target at $38 are justified from the risk/reward perspective at the moment.

Although ongoing worries over a glut in global supplies pushed crude oil to a fresh 2015 low, the commodity rebounded, finishing day above $46 per barrel. Is it another one-day rally or something more?

Yesterday, after the market’s open crude oil slipped to a fresh 2015 low of $44.20. Despite this drop, the commodity rebounded in the following hours supported by Chinese trade data, which showed that exports rebounded by 9.7% in December. Did this increase change anything? The answer to this question you will know in the technical part of today’s alert, meanwhile, let’s focus on major fundamental factor, which have weighed on prices in recent months – crude oil inventories. Yesterday, the American Petroleum Institute reported that last week crude stocks rose 3.9 million, while distillates gained 416,000 and gasoline increased 1.6 million. Therefore, if today’s EIA weekly report confirms these numbers and shows another increase in crude oil supplies (analysts expect the report to show that they rose by 417,000 barrels), the price of the commodity will likely move lower once again. Nevertheless, we should keep in mind that a smaller-than-expected increase or a decline will support the price and trigger a corrective upswing. Which scenario will we see later in the day? Before we know the answer to this question, let’s take a closer look at yesterday’s price action (charts courtesy of http://stockcharts.com).

For Larger Chart Go HERE

Looking at the daily chart, we see that although crude oil moved lower after the market’s open, the commodity rebounded, invalidating the breakdown below the previous low of $44.20. Additionally, yesterday’s white candle mateialized on huge volume, which together seem to be a bullish signal. But is it really so positive? When we take a close look at the daily chart, we notice that we saw similar one-day rallies in the previous weeks. Back then, although they paused (or triggered a small corrective upswings) further deterioration, in fact, they were only another stops before new lows. Taking the above into account, and combining it with the fact that crude oil is stil trading well below the recent highs and the 38.2% Fibonacci retracement (based on the mid-Dec-Jan decline), we think that lower values of the commodity are still ahead us. In our opinion, this scenario is currently also reinforced by the medium-term picture. Let’s take a look.

For Larger Chart Go HERE

From this perspective, we see that despite yesterday’s upswing, crude oil remains under the Apr 2009 lows, which serve as the nearest resistance at the moment. Therefore, as long as there is no invalidation of the breakdown below this area, a test of the barrier of $40 in the coming days is more likely than not.

Summing up, short positions are still justified from the risk/reward perspective as crude oil remains under the previously-broken Apr 2009 lows, the recent highs and the 38.2% Fibonacci retracement based on the mid-Dec-Jan decline. If the commodity moves lower from here, the first downside target for oil bears will be around $40.

Very short-term outlook: bearish
Short-term outlook: mixed with bearish bias
MT outlook: mixed
LT outlook: bullish

Trading position (short-term; our opinion):Short positions with a stop-loss order at $48.34 and an initial price target at $38 are justified from the risk/reward perspective at the moment. We will keep you informed should anything change.

Thank you.

Nadia Simmons
Forex & Oil Trading Strategist
Przemyslaw Radomski, CFA
Founder, Editor-in-chief

The collapse of the oil price has created losers and winners, and like every major movement in a commodity sector, the trick for investors is figuring out which side of the trade to be on. The most obvious victim of the slide in Brent and WTI prices over the last 6 months has been the major oil producers. Holders of these equities have seen price slides up to 33 percent. The question for oil company investors now is how to determine which of these companies are prepared to weather a sustained period of oil prices around $50 a barrel, or worse. Inevitably, those companies with high debt levels combined with high operating costs will be the first to get washed away. In contrast, low-leveraged companies with attractive cost structures are likely to survive. These companies will gain when the oil price comes back, and are the ones that investors should be eyeing right now.

But stock picking isn’t the only way to make money out of the butchered oil price. Here are 5 ways to position yourself for either a recovery or a further deterioration of the oil market, depending on where you place your bet.

1. Buy low-cost, low-debt producers

Oil production is, to say the least, a costly business. The cost of finding and “lifting” a barrel of oil out the ground varies between $16.88 in the Middle East to $51.60 offshore in the United States, according to the US Energy Information Administration. An analysis by Citi published by Business Insider shows that a significant amount of US shale oil production will be challenged if Brent prices move below $60 (Brent is currently at $49), and that companies are canceling projects that require prices above $80 a barrel to break even.

In this difficult price environment, investors want to buy companies that can produce at a lower rate than their competitors and do not have significant debts they need to service while having to accept lower commodity prices. Here are three possibilities:

Crescent Point Energy (NYSE, TSX:CPG): A conventional oil and gas producer with assets in Canada and the United States, Crescent Point can pull oil out of the ground at a cheaper rate than its Canadian oil sands rivals. Despite cutting spending by 28 percent in 2015 compared to last year, the Saskatchewan-focused firm is still planning to increase average daily production to 152,000 barrels. Crescent Point has a solid balance sheet, with net debt totaling $2.8 billion as of Sept. 30, against a market value of $11.55 billion. CPG also offers a very attractive 10.64% dividend at its current share price, leading to the speculation that its dividend could be cut if low oil prices persist. However, Crescent Point has stated that it will only cut its dividend as a last resort and has other levers at its disposal, including borrowing through one of its credit facilities or further reducing its capital budget later this year.

Husky Energy (TSX:HSE): Having gotten clobbered 25 percent over the last six months, partly due to cost overruns at its Sunrise oil sands project, upstream and downstream behemoth Husky now offers a respectable 4.69% dividend for buy and hold investors. Husky is pulling in the reins on spending, trimming $1.7 billion off its capital budget in 2015, mostly at its Western Canadian oil and gas operations. A third of Husky’s production in 2015 was natural gas, which has held up better than oil, and should provide smooth earnings going forward. The company will also get a bump in cash flow from its Liwan project in the South China Sea. This joint venture with Chinese company CNOOC is in its second phase and Husky will receive a 50 percent price premium on the gas compared to North American prices.

Suncor Energy (NYSE, TSX:SU): The Canadian oil sands giant has been a lean machine since scrapping its $11.6-billion upgrading plant back in 2013. As The Motley Fool pointed out in a recent piece, Suncor has dropped its operating costs from $37 per barrel in 2013 to $31.10 in the last quarter. The company is not being strangled by a high debt load as it contends with lower margins. SU had about $6.6 billion in debt compared to nearly $42-billion in shareholder equity as of Sept. 30, one of the lowest debt ratios in the industry, notes Motley Fool. Lastly, investors with a long view can take comfort from Suncor’s respectable 3.17% dividend.

2. Shift your individual stock holdings to an energy ETF

Picking energy stocks is tough at the best of times, let alone during this volatile, catch-a-falling-knife environment. Shifting to an energy ETF might be a better way to hedge oil risk right now. One possibility is the iShares S&P TSX Capped Energy Index Fund (XEG). The index includes energy stocks listed on the TSX, with the weight of any one company capped at 25 percent of the market cap of the index. Owning the ETF may be a good way to capture a short-term bounce in the energy market if momentum swings to the upside.

3. Short the oil price.

The time to begin shorting oil would have been 6 months ago, but those who believe crude has further to fall could still earn some gains if they time a short correctly. One way to do that is to purchase an inverse oil ETF. Zacks has a good article on 4 possibilities, including the popular ProShares Ultrashort DJ-UBS Crude Oil ETF (SCO). Another is the Horizon BetaPro NYMEX Crude Oil Bear Plus ETF (HOD). This derivative-based fund resets its leverage daily, making it a complex instrument that should only be used by experienced traders. An investor who bought HOD back in June would have realized a 6-month gain of 264.5%.

4. Short the service companies.

Oil producers have revenue coming in even though the price of oil is down. Oilfield service companies are beholden to producers to drill and service new and existing wells, making them especially vulnerable to falling prices. When the majors cut their capex budgets, oilfield service companies feel the pain. Hedge funds started shorting oilfield service companies in November, with CGG, Fugro and Seadrill among the most shorted stocks in Europe, according to Markit data quoted by Reuters. US-based short candidates include Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), Baker Hughes (NYSE:BHI) and National Oilwell Varco Inc. (NYSE:NOV).

5. Buy transportation stocks.

Lower prices for gasoline, bunker fuel and jet fuel have made winners out of airlines, shipping and trucking companies. Two examples are Delta Airlines, up 27.2% since June, and Canadian regional carrier WestJet (TSX:WJA), which has gained 19.2% in the same period. Transportation logistics companies such as TransForce Inc. (TSX:TFI), Saia (NASDAQ:SAIA), Echo Global Logistics (NASDAQ:ECHO) and J.B. Hunt Transport Services (NASDAQ:JBHT) may also be worth a look, although the dividend payouts on these companies tends to be meager or non-existent compared to the oil majors. The author does not hold positions in any of the above-mentioned equities. Due diligence is recommended before making any investment decisions.

The oil industry has experienced boom and busts before, but the depths to which oil prices have plunged have surprised everyone. Could the bust now persist much longer than many think?

It is not just oil that has seen a bust. Over the last decade and a half, the global economy has witnessed a massive commodity boom, with prices rising for all sorts of raw materials, including gold, iron ore, oil, gas, copper, wheat, corn, and more. But the commodity “super-cycle” appears to be over, with vast new supplies having come online in the last few years.

As prices rose through the 2000’s, multinational companies extracting all sorts of commodities planned billion dollar projects. With new mines, new oil and gas fields, and other commodity supplies hitting the market at the same time, a bust has ensued.

Related: Gains From Low Oil Prices Could Be Wiped Out This Year

“Supply has been outstripping demand not because demand has been particularly weak, but because there was too much supply,” Stephen Briggs, a commodities analyst at BNP Paribas SA, told The Wall Street Journal. “It looks like this won’t change anytime soon.”

The oil bust has captured worldwide attention in a way that crashing coal and copper prices have not. And for now, the bust may here to stay, at least a bit longer than many anticipated.

For example, Goldman Sachs sharply downgraded its assessment for crude oil prices. The investment bank now says that it sees Brent trading at around $42 per barrel over the next few months, down from its previous forecast of $80 per barrel. It also says that WTI will fall to $41, a downward revision of its previous $70-per-barrel prediction.

Many market watchers have predicted a “floor” in prices at each key threshold – $70 per barrel, then $60, then $50. But crude prices have ignored these forecasts, plunging to fresh lows each week over the past few months. Just last week, major hedge fund manager Andrew J. Hall said $40 would be an “absolute price floor,” another threshold that is within striking distance.

Saudi Prince Alwaleed bin Talal threw cold water on the markets even further with his recent comments.

“If supply stays where it is, and demand remains weak, you better believe it is gonna go down more. But if some supply is taken off the market, and there’s some growth in demand, prices may go up. But I’m sure we’re never going to see $100 anymore,” he said in an interview with USA Today.

Also, there is excess storage capacity that is allowing producers to continue to pump. Some companies are even storing oil on unused tankers at sea, betting that they can sell the volumes later at higher prices.

Finally, as oil prices fall, so do the costs of production. The cost of materials, along with the rates drillers pay to rent out rigs, deflate with the price of oil. That makes breakeven cost projections a bit of a moving target.

Related: Canada: A Microcosm Of The Ultimate Effect Of Low Oil Prices?

“To keep all capital sidelined and curtail investment in shale until the market has rebalanced, we believe prices need to stay lower for longer,” Goldman Sachs wrote in their latest report.

Speculators don’t know what to make of the oil markets right now. Some are pouring money into bets on prices rising, while others are wagering that prices have further room to fall.

We will learn more about the state of the U.S. oil and gas industry over the next few weeks as fourth quarter earnings are released. For the energy sector as a whole, profits are expected to fall by 19.1 percent. Some companies will be in worse shape than others, which could give us an indication of where production levels are heading, and with them, how long oil prices will stay low.

By Nick Cunningham of Oilprice.com

We have so far analyzed the current situation in the oil market, suggesting that falling oil prices can indicate another recession in the not so distant future. So the obvious question arises: would it be positive or negative for the gold market? The answer depends on whether gold is pro-cyclical or not. Some economists believe that gold, as oil, rises in a boom and falls during the bust. We consider that opinion too simplified. However, there are indeed strong arguments that commodity prices are strongly affected by the monetary policy responsible for the business cycle. Let’s analyze some data.

Usually commodity prices were booming during inflationary times: in the first years of 1920s, 1970s and 2000s. On the other hand, commodity prices were not performing well after the contraction of the money supply 1929-1933 and in the 1980s and 1990s due to the significant tightening of monetary policy implemented by Volcker (see chart 2). Commodity prices also fell significantly after Lehman’s collapse in 2008. Similarly, it seems that the recent drop in commodities prices means a popping of another inflationary bubble because of real or (just) perceived Fed’s monetary tightening. Although the U.S. interest rates did not really rise in 2014, investors are thinking ahead and shifting out of commodities today in anticipation of future higher interest rates in the next year.

Graph 2: IMF All Commodity Price Index from 1992 to 2014

Larger Image 

Why do we think that the bull market in commodities is over? Undoubtedly variability of commodity prices is not an unusual thing; however a recent supercycle was rather unique in terms of length and scope. Usually high prices do not last too long, because they encourage larger production. High prices are the only cure for high prices, the adage says. And usually the prices of commodities do not surge together. Why would we have supply shortages across the full range of commodities?

According to the popular theories, the rapid development of emerging markets, mainly China and India, was the real cause behind the commodities boom. Surely, this economic growth should not be neglected. However many analysts consider easy-money policy as a much more important factor explaining rising commodities prices. For example, according to this paper, growth of commodities was caused mainly by excess liquidity and not by demand from emerging economies.

So, how did it all start? The commodity boom began in late 2001, just as the Fed cut interest rates to counteract the recession after the bursting of the high-tech bubble. Lower interest rates encouraged banks to expand their lending. In turn, cheap funds induced entrepreneurs to extend their operations and investments, which stimulated demand for raw materials. Moreover, new and easy money entered commodities as the new “hot” investment destination for money managers. They were in a bear market since the early 1980s, but the growing demand from emerging markets called investors’ attention to this asset class.

Investors should also note that commodities were negatively correlated with the falling stock market at that time and low interest rates decreased the opportunity cost of investing in commodities. Professor Frenkel points out that the Federal Reserve cut real interest rates sharply in 2001-2004, and again in 2008-2011, which lowered the cost of holding inventories thereby contributing to an increase in demand. According to him, low real interest rates also increase the price of storable commodities by increasing the incentive for extraction tomorrow rather than today.

It is still not the full story. In that time the government deregulated pension funds, which started to diversify their portfolios by investing in commodities. Also, first commodity ETFs facilitated investments in that asset class. Professor Randal Wray calls this process the financialization of the commodities market and considers it as the main reason behind the commodity super cycle. Similarly, according to Yanagisawa, the speculative money inflows were one of the main factors explaining the rapid rise in oil prices. Now, if you add bubbles in emerging markets (alongside the real growth), the falling of the U.S. dollar and rising expectations of inflation stimulated by QE programs (in the second phase of the commodities bubble), you get a full picture of why and how a commodity boom was created.

We have talked so far about commodities in general. But what about gold? Does this all apply also to the yellow metal? For sure, gold in many ways behaves like all other commodities. The inverse relationship with U.S. dollar is the most important feature in common with other commodities. However, gold is not only the commodity; it also behaves like a currency. This is why the gold is so unique. Among the commodities considered in the above-mentioned analysis, only gold was not affected very significantly by the severe liquidity squeeze in 2007 and 2008, “implying that gold acted as a safe haven during the period of international financial dysfunction”. Therefore, although commodities in general are to a large extent pro-cyclical, gold breaks out of this simple scheme.

Thank you.

The above article is based on the January issues of our Market Overview reports. We invite you to stay updated on the latest developments in the commodity market and global economy by joining our gold newsletter. It’s free and you can unsubscribe in just a few clicks.

With interest rates front and center these days, I thought we would take some time to explore the yield curve and some of the information that can be gleaned from it. The yield curve represents the relationship between interest rates on bonds of different maturities, but equal credit quality. For our purposes, we’ll be discussing the US Treasury yield curve.

The slope of the yield curve has proven to be a good forecaster of economic growth. There are three basic shapes the yield curve can take, each with different implications regarding economic growth. We’ll explore these below and then take a look at the what the current yield curve is saying.

A normal, upward sloping yield curve is shown below. This is how the yield curve looks when an economy is growing and investors are confident. In a growing economy, investors demand additional premium (yield) for longer maturity bonds. This is logical considering there is more risk associated with having money tied up for longer periods of time. Healthy economies nearly always have an upward sloping yield curve, although the interest rates that make up that curve may differ substantially from one period to another.

A flat yield curve indicates that investors are not being compensated for the additional risk of longer maturity bonds. This is a warning sign that an economy is under duress; investors expect slow growth, and economic indicators are sending mixed signals. As investors buy and sell bonds to flatten the yield curve, they are demonstrating through their behavior that they are worried about the outlook of the economy. As a result, they prefer to have their money tied up longer in safe investments, and demand less of a return for doing so.

A flat yield curve can develop into the dreaded “inverted” yield curve when the economic outlook is very bleak. When the yield curve inverts, it indicates tough economic times ahead. The logic goes like this: If I’m worried the economy is going to crash, I want to look for safe ways of preserving my capital. If I suspect falling equity prices, and falling interest rates, I’m going to try to lock my capital away in longer-term bonds as a way to ride out the storm. As more and more investors do this, it drives longer maturity bond prices up, and the yields down. These same investors will shy away from short-term bonds, which may have to be reinvested during the downturn. This lack of demand drives short-term treasury prices down and the yields up.

There are multiple ways to analyze the slope of the yield curve, so which is the most accurate? Statistically, the method that has shown the most reliability in predicting future economic growth has been to look at the difference between the rates on the 10-year Treasury Note and the 3-Month Treasury Bill. When the yield on the 10-year is greater than the yield on the 3-Month, the slope is positive, and when this relationship reverses (3-Month rate greater than the 10-Year rate), the slope is negative and the yield curve is considered inverted.

Historical observations using this method show that an inverted yield curve indicates a recession approximately one year away. Inverted yield curves have preceded each one of the last seven recessions, as can be seen on the chart below.

This chart contains a wealth of information, so let’s study it carefully. On the chart, the brown line represents the measure of slope we just discussed (the difference between yields on the 10-Year Treasury Note and the 3-Month Treasury Bill), going back to 1953. Each time this brown line drops below zero, the yield curve is considered to be inverted. Notice that this occurs immediately preceding the last seven gray vertical bars — which indicate recessions as defined by the Bureau of Economic Analysis.

The blue line shows GDP growth, and for the purposes of this chart, the GDP figures have been shown with a lag of one year. Looking at the chart with this lag allows us to see how closely correlated an inverted yield curve is with a drop in GDP one year out.

The last time the yield curve inverted was in August 2006; it provided advance warning for the recession that “officially” began in December 2007. Before that, the yield curve inverted in April 2000, predicting the 2001 recession. The only time this indicator gave a false signal was in 1966.

I’m guessing some of you are wondering whether this relationship will still hold in light of the massive amounts of quantitative easing. If I had to venture a guess I would say yes, and here’s why. First, the FED can generally control short-term rates, but has much less effect on long-term rates, which are typically set by the market. Second, even the FED’s control of short-term rates is not perfect, as evidenced by previous spikes in short-term Treasuries.

So what is the yield curve saying now? A sustained strong demand for Treasuries, combined with the recent rush to safety, has pushed the yield on the 10-year down below 2%. We have to look back almost two years, to when the Fed was heavily engaged in QE, to find a sustained period of rates this low. If the Fed does want to reduce the size of its large balance sheet by selling longer-dated bonds, this would be an opportune time, as a global rush for safety and yield is suppressing rates in a way the Fed could only have dreamed of.

With short rates held at zero, continued declines in the yield on longer dated maturities are acting to flatten the yield curve. In the chart below, the red line shows the current state of the yield curve. The black “trail” shows where the yield curve has been recently. As you can see, the yield curve is flattening, and this has precarious economic implications.

At this moment we should be attentive but not overly concerned. What will be interesting to see is how the yield curve responds to changes in Fed policy. I will go into much more detail on this topic in upcoming remarks, but prior to the financial crisis it was actually the Fed raising short rates, without the long end rising in tandem, that triggered the inverted yield curve which preceded the last recession. The curious side of me is constantly wondering if, when the Fed finally decides to tighten, it would be a better idea to sell longer dated maturities (which would theoretically raise the long end of the curve), rather than raise the short end of the curve and “hope” it translates out. If I were Fed Chairman for a day, there is a good chance that would be my course of action.

Perhaps we shouldn’t be surprised that investor behavior is acting to flatten the yield curve. After all, the Eurozone economy is stagnant, Japan is in recession, China’s economy is slowing, and oil exporting countries and their currencies are under pressure. If it weren’t for a robust US economy, including solid gains in employment and corporate profits, I would be deeply concerned. What we need to watch closely here is to what extent global conditions act as an anchor for the US economy, or whether worldwide conditions finally begin to improve as a result of continued central bank stimulus and renewed global growth.