NYMEX: WTI Crude Oil (
CL1!
), Micro Crude Oil (
MCL1!
)
The talk of inflation deceleration created a wishful misperception. Does a CPI read from 9.1% to 4.0% mean price relief for consumer? Certainly not. Something costed $1 last year will go up to $1.04 this year on average. What really comes down is the rate and the pace of price increase, but the absolute price level has forever gone up.
This makes the real decline in energy prices more extraordinary:
• On June 23rd, WTI crude oil (
CL
) August futures settled at $69.16 a barrel. This is 44% below last June’s high of $123.70;
• At $2.44 a gallon, RBOB gasoline futures (
RB
) declined 34% year-over-year;
• At $2.37 a gallon, ULSD diesel futures (
HO
) price dropped 45% YoY.
• At the retail level, the American Automobile Association reports the national average regular gasoline price at $3.57 a gallon on June 25th, down 27% YoY;
• The AAA diesel price is now $3.89/gallon, falling 33% YoY.
However, the era of low energy prices may be coming to an end. I am convinced that the market dynamic has changed. Elevated geopolitical tension, higher demand and a weak dollar could help pull crude oil out of the bottom, and onto an upward trajectory.
Global Tension Forms Solid Price Support
A week after the start of Russia-Ukraine conflict in February 2022, Crude oil futures shot up 30% from below $90 to $115. WTI peaked at $121 in June as the fighting continued.
Since then, high inflation and rate hikes raised the risk of global recession. As the demand outlook dimmed, oil price lost support and trended down in the past year.
Geopolitical tension may have been placed on the back burner, but it never went away. Last Saturday, the Russian private army Wagner Group mounted a short-lived rebellion against the Kremlin. What this means to the Ukraine conflict and the stability of Russia itself remain to be seen.
Geopolitical crisis could cause supply shock and raise the price of crude oil. My observation is that global tension will be at an elevated level throughout 2023 and 2024.
Oil Demand is Expected to Recover
Last July, I called the peak of gas price in this report. I discovered that record $5 gas had caused demand to fumble. AAA gas price surprisingly declined at the start of the traditional summer driving season.
Things look different now. Retail gas price creeped up 50 cents (+13%) since December. Many stations popped up gas price ahead of the July 4th holiday. With a still strong job market and inflation in check, consumers are taking their summer vacations.
A second key demand factor comes from the US government. The Biden Administration has drawn down the Strategic Petroleum Reserve (SPR) to fight high oil price in the last two years. The Energy Information Agency data shows that the SPR holds 350 million barrels of crude oil as of June 16th. This is 285 million barrels less than the level on January 24th, 2020, the week when President Biden first took office. SPR is now at a critical four-decade low level.
The Department of Energy has begun replenishing the SPR. It announced buying up to 3 million barrels in May, and recently planned additional purchase of 6 million in August.
Thirdly, the risk of global economic recession is now lower than what we previously feared. This is my most important reason for raising the outlook of future oil demand.
• The Federal Reserve implemented ten consecutive interest rate increases since March 2022. US inflation rate has declined from the peak of 9.1% to 4.0% in May. Lowering inflation may have averted the US economy from falling on a hard landing.
• The banking failures, from Silicon Valley Bank to Signature Bank, First Republic, and Credit Suisse, have met with swift government rescue efforts. We have so far managed to contain these from spreading to systemic risk.
• The resolution of US debt ceiling crisis helped avoid a US default and a likely global financial crisis it may trigger. According to the USDebtClock.org, the US national debt is now $32.1 trillion, which is $700 billion more than the previous debt limit.
• The Biden-McCarthy deal in federal spending limits ensures that government budget will not be cut. The federal government accounts for one quarter of the US economy. As bad as it may sound, government spending spree with borrowed money does contribute to near-term economic growth. We just kick the can forward and leave the debt burden to future generations.
A Weak Dollar Supports Higher Oil Price
Last year, the main investment theme of global commodities market was “Strong Dollar, Weak Commodities” and “High Rate, Low Price”. We are now in a reverse course.
The US dollar index peaked at 114 in last September. While the Fed raised rates aggressively, other countries were slow in response, resulting in widening interest rate spreads between the US dollar and major foreign currencies. Since then, the Fed reduced the size of rate hikes from 75 bp to 50 and then 25, while UK and ECB caught up with bigger rate increases. The dollar index has fallen to 100 by April.
The Fed paused rate increase in its June meeting. Although it emphasizes in fighting inflation, there is no question that the monetary tightening cycle is now in its last stretch.
NYMEX WTI Crude Oil Futures
With the key factors discussed above, plus the OPEC having incentive to cut output, I could see WTI going back to the $80-$90 range.
December WTI (CLZ3) currently quotes $69.1 a barrel. Each contract has a notional value of 1,000 barrels. Margin requirement is $5,000 to place one contract.
Hypothetically, if Dec futures goes up to $80, one long contract would gain $10,900 (=10.9*1000). Theoretical return would be +118% (=10,900/5,000-1), excluding transaction fees.
The risk of long WTI is falling oil price. If CLZ3 falls to $65, a long position would lose $4,100. This would result in a Margin Call, with the Exchange requiring the trader to deposit fund and bring the account balance back to $5,000.
Alternatively, we could consider the Micro Crude Oil Futures ( MCL ). Contract size is one tenth of the standard CL contract. And so is the margin requirement. Everything else works the same.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/
CL1!
), Micro Crude Oil (
MCL1!
) The talk of inflation deceleration created a wishful misperception. Does a CPI read from 9.1% to 4.0% mean price relief for consumer? Certainly not. Something costed $1 last year will go up to $1.04 this year on average. What really comes down is the rate and the pace of price increase, but the absolute price level has forever gone up.
This makes the real decline in energy prices more extraordinary:
• On June 23rd, WTI crude oil (
CL
) August futures settled at $69.16 a barrel. This is 44% below last June’s high of $123.70; • At $2.44 a gallon, RBOB gasoline futures (
RB
) declined 34% year-over-year; • At $2.37 a gallon, ULSD diesel futures (
HO
) price dropped 45% YoY. • At the retail level, the American Automobile Association reports the national average regular gasoline price at $3.57 a gallon on June 25th, down 27% YoY;
• The AAA diesel price is now $3.89/gallon, falling 33% YoY.
However, the era of low energy prices may be coming to an end. I am convinced that the market dynamic has changed. Elevated geopolitical tension, higher demand and a weak dollar could help pull crude oil out of the bottom, and onto an upward trajectory.
Global Tension Forms Solid Price Support
A week after the start of Russia-Ukraine conflict in February 2022, Crude oil futures shot up 30% from below $90 to $115. WTI peaked at $121 in June as the fighting continued.
Since then, high inflation and rate hikes raised the risk of global recession. As the demand outlook dimmed, oil price lost support and trended down in the past year.
Geopolitical tension may have been placed on the back burner, but it never went away. Last Saturday, the Russian private army Wagner Group mounted a short-lived rebellion against the Kremlin. What this means to the Ukraine conflict and the stability of Russia itself remain to be seen.
Geopolitical crisis could cause supply shock and raise the price of crude oil. My observation is that global tension will be at an elevated level throughout 2023 and 2024.
Oil Demand is Expected to Recover
Last July, I called the peak of gas price in this report. I discovered that record $5 gas had caused demand to fumble. AAA gas price surprisingly declined at the start of the traditional summer driving season.
Things look different now. Retail gas price creeped up 50 cents (+13%) since December. Many stations popped up gas price ahead of the July 4th holiday. With a still strong job market and inflation in check, consumers are taking their summer vacations.
A second key demand factor comes from the US government. The Biden Administration has drawn down the Strategic Petroleum Reserve (SPR) to fight high oil price in the last two years. The Energy Information Agency data shows that the SPR holds 350 million barrels of crude oil as of June 16th. This is 285 million barrels less than the level on January 24th, 2020, the week when President Biden first took office. SPR is now at a critical four-decade low level.
The Department of Energy has begun replenishing the SPR. It announced buying up to 3 million barrels in May, and recently planned additional purchase of 6 million in August.
Thirdly, the risk of global economic recession is now lower than what we previously feared. This is my most important reason for raising the outlook of future oil demand.
• The Federal Reserve implemented ten consecutive interest rate increases since March 2022. US inflation rate has declined from the peak of 9.1% to 4.0% in May. Lowering inflation may have averted the US economy from falling on a hard landing.
• The banking failures, from Silicon Valley Bank to Signature Bank, First Republic, and Credit Suisse, have met with swift government rescue efforts. We have so far managed to contain these from spreading to systemic risk.
• The resolution of US debt ceiling crisis helped avoid a US default and a likely global financial crisis it may trigger. According to the USDebtClock.org, the US national debt is now $32.1 trillion, which is $700 billion more than the previous debt limit.
• The Biden-McCarthy deal in federal spending limits ensures that government budget will not be cut. The federal government accounts for one quarter of the US economy. As bad as it may sound, government spending spree with borrowed money does contribute to near-term economic growth. We just kick the can forward and leave the debt burden to future generations.
A Weak Dollar Supports Higher Oil Price
Last year, the main investment theme of global commodities market was “Strong Dollar, Weak Commodities” and “High Rate, Low Price”. We are now in a reverse course.
The US dollar index peaked at 114 in last September. While the Fed raised rates aggressively, other countries were slow in response, resulting in widening interest rate spreads between the US dollar and major foreign currencies. Since then, the Fed reduced the size of rate hikes from 75 bp to 50 and then 25, while UK and ECB caught up with bigger rate increases. The dollar index has fallen to 100 by April.
The Fed paused rate increase in its June meeting. Although it emphasizes in fighting inflation, there is no question that the monetary tightening cycle is now in its last stretch.
NYMEX WTI Crude Oil Futures
With the key factors discussed above, plus the OPEC having incentive to cut output, I could see WTI going back to the $80-$90 range.
December WTI (CLZ3) currently quotes $69.1 a barrel. Each contract has a notional value of 1,000 barrels. Margin requirement is $5,000 to place one contract.
Hypothetically, if Dec futures goes up to $80, one long contract would gain $10,900 (=10.9*1000). Theoretical return would be +118% (=10,900/5,000-1), excluding transaction fees.
The risk of long WTI is falling oil price. If CLZ3 falls to $65, a long position would lose $4,100. This would result in a Margin Call, with the Exchange requiring the trader to deposit fund and bring the account balance back to $5,000.
Alternatively, we could consider the Micro Crude Oil Futures ( MCL ). Contract size is one tenth of the standard CL contract. And so is the margin requirement. Everything else works the same.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
