• Following a series of recent highs, crude oil now in bearish trend
• Changing fundamentals point to continued weakness, while US demand increasingly suspect
• Large speculator long positions will exacerbate any future downturn

On August 10, we downgraded our outlook on WTI from neutral to bearish thanks to a significant deterioration of the trend. We determine trends for a number of major currencies and commodities based on price, trading volumes and changes in volatility. Following WTI’s latest top at $75.37/barrel, sell-offs in the commodity have been accompanied by accelerating trading volumes. This is a bearish sign that suggests that traders are selling crude oil with conviction. The trend in underlying volatility (based on the CBOE crude oil volatility index) also suggests increasing volatility in the foreseeable future.

Since that time, the commodity has fallen by about 4% based on crude oil futures traded on the NYMEX. Beyond a bearish quantitative trend, we expect (1) weakening fundamental dynamics, (2) peaking US growth, and (3) a significant speculator long position to weigh on crude oil prices going forward.

Crude oil fundamentals now foreshadowing a downturn

In recent history, major turning points in crude oil prices have coincided with changes in supply versus demand growth. This is visually represented below. Note that year-over-year changes have been smoothed out by using a 3-month moving average.

YoY supply growth vs. YoY demand growth: past the flip

(Click on image to enlarge)

Source: US Energy Information Administration, MarketsNow

As can be seen above, changes in demand growth versus supply growth have accurately foreshadowed long-term tops and bottoms in the crude oil market. Crude oil prices began a bottoming process in late 2015, once demand growth overtook supply growth.

In the second quarter of this year, supply growth has once again overtaken demand growth. Unsurprisingly, the commodity began a topping process shortly thereafter, reaching its most recent highs in late May and early July 2018.  

Another way of looking at this same dynamic is to look at the balance between crude oil demand and supply. This is shown below. Note that monthly changes in the supply versus demand balance have been smoothed out by using a 3-month moving average.

Supply versus demand balance: heading into the flip

(Click on image to enlarge)

Source: US Energy Information Administration, MarketsNow

As can be seen above, crude inventories grew during the bear market in early 2015. Following the bull market that began in early 2016, inventories mostly fell each month. Going forward, changing fundamentals are likely to cause crude oil inventories to begin rising again. Thus the fundamental picture for crude oil, based on underlying supply and demand, is likely to weigh on prices in the near future.

US demand increasingly suspect

Looking at the world’s major economic regions, the United States has been this year’s standout performer. The Eurozone began slowing in rate-of-change terms in the fourth quarter of 2017. Meanwhile, Chinese growth has also been slowing (albeit not according to highly suspect official data) following a significant stimulus program in early 2016. Other emerging market economies have also been slowing, a factor that has weighed on emerging market stocks this year.

While accelerating US growth kept crude oil prices supported, the main engine behind new demand is now running out of steam. This can be seen as US commercial inventories are now rising in rate-of-change terms. This is shown below:

US commercial inventories: the bottom is in

(Click on image to enlarge)

Source: US Energy Information Administration, MarketsNow

As can be seen above, US commercial inventory growth has been weakening since early 2016. Thanks to growing US demand (which has more than made up for US production in recent history), inventory growth dropped to as low as -11.4% in the second quarter of 2018. Since that time, the trend has changed, and inventory growth is now accelerating in rate-of-change terms. Crude inventories grow when demand can no longer absorb increases in supply. According to the US EIA’s forecasts, inventory growth is expected to turn positive later this year.

Big speculator positions look vulnerable to panic

In our weekly analysis of the Commitments of Traders Report (available on our website), we compare the net speculator position in crude oil futures and options contracts against trailing 12-month and 36-month averages. When the position is more than two standard deviations greater than historical averages, we flag the position as looking extended.

As net speculator positions in crude oil have been large for a fairly long period of time, positioning is no longer looking extended based on our indicators. Nonetheless, the aggregate number of long positions is fairly large and may exacerbate a downturn. This is shown below:

Crude oil net speculator positions: one-sided

(Click on image to enlarge)

Source: CFTC, MarketsNow

As can be seen above, net speculator positions in crude oil futures and options first peaked just under 600,000 contracts net long in early 2017. As a proportion of total interest, the speculator long position was just above 20% of the total. More recently, WTI prices peaked when speculators were just under 800,000 contracts long the commodity. This was once again just above 20% of the total interest.

While the speculator long position is no longer as stretched, it remains undeniably large by historical standards. At the outset of the crude oil bear market in 2016, net long positions in crude oil were less than 250,000 contracts and 10% of the total open interest. Should crude oil remain weak, significant speculator long positions could exacerbate the sell-off meaningfully.

Changing trading patterns and fundamentals point to an upcoming downturn

Historically, crude oil bull markets have been characterized by concerns regarding supply bottlenecks, while bear markets have been characterized by concerns regarding demand. Looking at recent trading patterns, the narrative driving the commodity has recently flipped.  

During the bull market that began in early 2016, crude oil prices routinely ignored higher-than-expected inventory data releases. Over the past week, crude oil prices have weakened sharply in response to higher-than-expected US inventory figures. At a minimum, this shows that traders are increasingly paying attention to concerns regarding future demand. This is a sign that rising inventories (an indicator of weak demand) now matters again.

Beyond changes in trading patterns, fundamentals are now weighing against the commodity as supply growth continues unabated while demand growth is more likely to slow. Finally, large speculator long positions in crude oil are a significant risk and indicate that the commodity could fall sharply in a downturn. Looking forward, expect crude oil prices to keep weakening.