Crude oil touches nearly every part of our lives throughout the day. The more we do, the more we use. This is what makes crude oil such a valuable economic forecasting tool. This week, we'll look at the big picture in crude oil using technical, fundamental and spread data to explain what the market is telling us as we head into the summer months.
First, we'll examine the basic pricing structure. Then, we'll move to the spread charts to illustrate the timing of the current situation. Crude oil is a physical commodity. It has to be drilled, refined, shipped and stored. All of this costs money. Storage, insurance and inflation all combine to raise prices along the timeline. The longer the maturity date of the contract, the higher it should be priced. The width of the point spreads between the current and deferred months reflects the economic expectations of the crude oil market. Widening spreads and rising prices indicate increased expectations of future demand. Narrowing spread values forecast declining economic activity. We've run the quarterly spreads out to next March in the chart below.
Each of the charts is a quarterly spread. The two most important points are that the spread declines substantially from the current quarter through March of 2017. This is a clear forecast of declining demand relative to our current level. Secondly, the spread from the current June, front month and the March 2017 contract is less than $1. This puts energy inflation at 2% over the next 9 months. This seems optimistic.
We feel the spread markets indicate that we are nearing a cyclical high. Moving to the weekly Commitments of Traders data we'll point out several reasons why the high may already be in as well as a projected top and advantageous selling price should this rally continue. First, a brief technical analysis 101 refresher. One of the hallmarks of a trend is growing volume and open interest as the market moves in a single direction. We can apply this to the Commitments of Traders report by comparing the net and total positions of the various trader groups. Note that speculative buying jumped on board the bottom in early February. Their net position grew through the March and then April highs before declining in the last two weeks. Furthermore, the speculative total position began declining shortly after the crude oil market turned higher in February. This shows that speculative interest was skewed more towards offsetting shorts leaving the market on the rally than new longs entering. This is the type of data that we analyze behind the publication of our nightly email service, Cot Signals. We've also made our mechanical crude oil trading program's equity curve available to everyone on the site.
Technical analysis 102, the bearish divergence. Lets rewind to the summer of 2014. Crude oil was still above $100 per/bbl. In fact, it had been there so long, we had begun to accept it as the new $40 per/bbl. The crude oil market tried to rally at the behest of the large speculators who'd accumulated more than 400,000 contracts. Meanwhile, commercial traders (oil drillers) had just set a record net short position. Crude struggled higher through the end of June but at no point did the market momentum indicator confirm the market's rally by making a new high of its own. A bearish divergence is when new highs in price are not confirmed by higher highs in the underlying momentum indicator. The bearish divergence and the speculative long washout it created as the market fell below $100 per/bbl is a classic study in the way market momentum and the Commitments of Traders report can be used to spot unconfirmed tops or bottoms in any CFTC tracked commodity futures market.
Finally, the last point to make on the weekly crude oil chart lies with the downward sloping trend lines. The primary dates back to the July 2014 high and still provides context for broad overhead resistance. Of more importance are the two small, nearly parallel downward sloping trend lines that could very well be signaling a bull flag, which could lead to an exhaustive rally. This will be triggered by a June close above $45.75. The measured objective is approximately $48.50. Market action leads me to believe we'll get this last leg of the rally. What I'll be watching closely for is momentum confirmation. A lower high in the next week could signal the end of the Nigerian supply fears and bring us back to a world where 2% inflation would be a great thing.
