The Real Reason for Last Week's "Oil Flash" - and Why Crude Prices are Moving Back Up

The Real Reason for Last Week’s “Oil Flash” – and Why Crude Prices are Moving Back Up

by | published May 10th, 2017

Late last week, crude oil prices took a nose dive. WTI (West Texas Intermediate, the benchmark crude rate for futures contracts in New York) declined 4.8% on Thursday, fueled by massive overnight (and overseas) sell-offs. That translated into a 7.7% dive for the week to date.

If there has ever been a better example of the tail wagging the dog, I haven’t seen it.

As you’ve seen me say before, swings in oil prices often have less to do with market dynamics and more to do with paper traders – people trading futures, options, and other hedges. Of course, what does happen in the actual market may be the initial prompt for how such derivatives are played.

This time, however, we had an avalanche of events that magnified the impact.

Here’s what happened – and where oil is heading next…

The Concerns Used to “Justify” the Crash Have All Been Answered

It began in the U.S. markets as main trading support levels weakened, prompting the unwinding of long positions.

Now, there were no new developments to bring this about. Questions over whether OPEC would extend production cuts/caps in June for another six months, a rise in U.S. extraction rates, and concerns over demand levels remained.

But all these concerns have been in vogue for some time.

And all of them have already been answered…

The OPEC restraint will almost certainly continue for at least the rest of this year. Some discussion has emerged over whether the cartel and main non-member producers like Russia would increase the reductions. But that (however unlikely) has nothing to do with maintaining the current floor for prices.

Meanwhile, U.S. production has been increasing. Yet the levels reached by the beginning of May have also resulted in something beyond pressuring prices. The current level is once again putting the very companies raising production under the threat of a renewed round of debt default.

In other words, the production growth is not sustainable.

The operators most fueling the aggregate production rise are almost literally one step ahead of the sheriff, producing and selling to stay afloat. However, the cash flow is eaten up (and then some) by the increasing cost of the debt load.

At current prices, there is no basin in the U.S. where wellhead prices (the first level when production comes out of the ground and the price received by the operator) are profitable. Wellhead prices run about 15% or more below market price. With market prices south of $50, these companies leading the production rise are once again facing revenue levels insufficient to survive.

Finally, the angst being expressed about oil demand not growing is a chimera. Demand continues to be well within seasonal margins in the American market and is once again expanding elsewhere.

In short, the price collapse last week had little to do with oil – but a lot to do with paper cut on oil. That makes for a textbook example of a flash. This was all about technical hijinks.

Here’s how it all went down…

Once the Computers Took Over, the Dip Turned Into a “Flash”

Antsy traders overreacted to crude approaching some technical support levels. After a tug-of-war between bulls and bears over several weeks, WTI breached its 200-day moving average. Given the large number of long positions in the market, traders started selling those out of fear. That added additional pressure downward.

Two matters then took over.

First, the year’s low for oil prices came to be seen as the next solid support level. Second, a series of esoteric indicators derivative traders use to handicap market moves came into play. Called “Fibonacci retracements,” they comprise taking extreme pricing points (a peak high and a trough low), and then divisions of the vertical distance between them by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. The statistical result is then applied to other factors in arriving at optimal buy and sell levels.

Don’t worry if you have no idea what this means.

Many of the guys using them don’t really understand them either. But here’s the issue…

These “Fibonacci retracement” price levels are used as triggers for automated computer trades. Once the price of oil hits one of them, a computer performs the pre-determined trade, no matter what else is happening.

These “retracements” are static figures, not moving averages. That means they cannot compensate very well to either rising trading volume or artificially exaggerated pricing.

The problem last week was then compounded by foreign trading overnight and a rush into options contracts to cover the moves from long to short positions. Those options represented at least 520 million barrels of underlying oil by the time the frenzy had subsided early on Friday.

That’s the third highest level on record, and represented far more than the entire global amount of actual crude trading for the entire day.

But that wasn’t the end of the over-exaggeration…

Options Traders Added Insult to Injury

Things were blown even more out of proportion by the frequency of trade.

Initial estimates had NYMEX data showing WTI open interest (the amount of open options contracts) rising to a record 2.27 million contracts on Thursday. That merely accentuated the action overnight.

The number of WTI contracts traded in a minute, typically in the hundreds early in the trading day, surged above 7,000 by 4:30 AM London time.

One trigger tripped another as computers around the world magnified nonevents into a major downward result. The artificial technical ways in which traders attempt to find points at which to make transactions just before the markets move ended up distorting the market itself.

The computers controlled the market, rather than the other way around. The tail wagged (more like hammered) the dog.

This reminds me of a well-known phrase – to err is human. But if you really want to screw things up, throw in a computer.

There is no better way of indicating the overreaction than to realize what is happening right now…

Where Oil is Heading Next

As I write this, WTI prices are surging 4%, virtually reversing all the dive from Thursday and Friday last week.

The rationale given by the pundits, the same guys who were touting oil’s free fall only a few hours ago, is a decline in production (more than 5 million barrels in the U.S.) and rise in demand.

Of course, as you’ve already seen, these signs were never really the cause of the problem to begin with.

So don’t worry about last week’s “oil flash.” Prices will recover.

P.S. Ever since the Saudi’s declared their oil war, American oil companies have been struggling to make ends meet. Last week’s “oil flash” only made things harder.

That’s why I created a brand-new research company – the Energy Capital Research Group – so I could compile the hardest data in existence on which companies will go under…

And which will survive…

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See my briefing here.

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  1. May 16th, 2017 at 16:05 | #1

    Russia is, in my opinion, deteriorating. Émigrés with whom I have spoken tell a story of desperation, rising poverty levels and lack of assistance from the government. And yet the government blusters and tells the world how strong, how effective, how productive their nation is. Clearly,Russia needs markets for its petroleum products, and its hope of using its huge complicated pipeline scenario is not working. Again, and also clearly, a few thousand miles away is a very strong, technologically advanced Iran that is selling LGN hand over fist, including sales to Western Europe which probably causes Gazprom gas (forgive the pun). Can Russia compete? Given the apparent rapprochement of the United States and Russia , and giving the fact that the United States is demonizing Iran, do you see armed conflict between Russia and Iran on the horizon which is fueled by United States and Israel? Both the United States and Israel have been increasing their diatribes against Iran. If war does come, I suspect that the 1st bombs will destroy the LNG facilities, which are currently producing an extremely high level of LNG. Then, of course, the United States would let fly with its huge blockbuster bombs against the atomic energy sites in Iran.

    Do you think this is a realistic scenario? Thank you, Dean Brunel

  2. Jose Rolz
    May 19th, 2017 at 21:37 | #2

    The best thing that could happen to stabilize world politics is for Russia and the USA to become allies. That would make it a bi-polar world again; only this time without the “Cold War”. This, of course, will not happen if the Leftist and the Liberal press maintain their “pressure” on the White House. China is the real “problem” for the USA going forward, not Russia. The Chinese Military has much more of influence in how China goes, than the Chinese politicos, trust me. If not, how do you think North Korea maintains such a belligerent position and their military continues nuclear tests and developing a “delivery capability”. They are just surrogates for the Chinese Military. But the ” Pros at the US State Department ” can’t see the forest for the trees”. With respect to Iran, let’s see first how their “Presidential Election” goes. Have a great one. Jose’ Rolz

  3. R. L. Barrett
    May 31st, 2017 at 22:53 | #3

    Naw Dean Brunel, The Russians and the Iranians are actually doing a lot of trade. You are right that the Russians who are leaving Russia and looking of ra better life are the ones that are not happy. When I was there in 2015 they were pretty upbeat as a whole. I suspect that the most likely problem area is still North Korea as far as war goes. But, the Russians are supporting the OPEC oil pumping limits so far and I suspect they will continue. The Saudi move to wipe out the Americans failed miserably and I don’t see them being able to push prices higher. Some of the American producers have refined their technology are now making a small profit at $40 a barrel and that really puts a limit on any OPEC plan to jack prices up again. The higher the prices go the more American oil is an threat. OPEC got greedy and they killed the goose that was laying their big black eggs. They are going to see long term low prices for oil and until the demand explodes or something else changes the world the oil business is going to be tough. I have a fair piece of change invested in oil and I wish it looked better. But, I still have positive cash flow, just not as much. And, I don’t think the Saudi’s or OPEC have the stomach to try to corner the oil market again.

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