Oil is breaking down from key moving averages, a sign that economic momentum is weakening.
Recessions can be very opportunistic for trading oil, as volatility spikes around these episodes. A huge drawdown into the economic slump, followed by a sharp recovery, is the typical pattern.
In this article we show how you could play it.
Downgrading Oil From Neutral (5) to Sell (4)
Our most recent work on oil contained in this article has led us to downgrade our rating for oil from neutral (5) into the sell zone at 4:
- Price continues to break down below key moving averages
- Middle-East tensions appear to be de-escalating
- There are increasing signs of economic weakness
If price reverts to trade above the key moving averages, we’ll change our rating back to neutral.
For now, oil is setting up to become a great trading opportunity as we highlight in this article.
Here’s How We’re Looking to Play Oil
Oil is a volatile asset class that gets even more volatile around recessions, creating trading opportunities:
- Oil’s price swings around recessions are even bigger than those of stocks
- The moves follow a typical pattern across recessions, making them tradable
- With good risk management it can add considerably to your portfolio’s returns
Oil has typically followed this pattern around the last 4 recessions:
- It sees a big drawdown going into them (in some cases preceded by a melt-up)
- That’s followed by a sharp rebound as the economy gets out of the hole
We believe that oil is setting up into a unique trading opportunity here:
- It’s rare to find assets that exhibit such high volatility like oil does around the business cycle
- It can generate substantial profits on both the short- and the long-side
- Timing the rebound would position us favorably for riding the next oil bull market
Is a Big Drawdown in Oil Imminent?
Here are some factors that are shaping our view of where we see oil headed in the next 6-12 months:
- Upside looks limited as signaled by subdued bond market inflation expectations and a weakening consumer
- It’s fairly-valued relative to where we are in the business cycle, so a breakdown in technicals signals more downside
- The Israel-Hamas war appears to be de-escalating but remains a tail risk for an oil spike
- Fiscal stimulus in China hasn’t happened yet but when it does it could unleash consumer animal spirits and drive oil demand higher
Let’s get into each of them in a bit more detail now.
Oil Upside Looks Capped
Bond market inflation expectations (i.e., inflation breakeven rates) have proven leading indicators of oil in the post-pandemic years:
- Anticipated turning points in oil (i.e., 2020 Covid rebound and 2022 price peak)
- Predicted that oil’s recent surge would prove short-lived (as we forecasted 2 months ago)
We agree with the bearish view from breakeven rates. They’re telling us that the bond market doesn’t expect oil to move higher for a couple of reasons:
- A determined Fed will crush demand before letting inflation get out of hand again
- Consumer spending is already weakening, dragging demand for gasoline
Credit card spending is deteriorating quickly, falling to levels seen in late-2020. Pandemic savings have largely run out, forcing consumers to tap their credit cards.
We’ll Turn More Bearish on Oil if Technicals Worsen From Here
Oil prices are volatile and often overshoot economic data. While weakness in the PMI has often led oil to overshoot lower, that’s not the case today:
- Oil prices look consistent with current manufacturing weakness, meaning more downside if the economy weakens further (stocks, on the other hand, look overvalued)
- We expect the manufacturing PMI to weaken to 40 from today’s level of 47, and oil prices to follow it lower
- We need technicals to break down further to turn more bearish on oil
Key technical setups we’re watching on oil that would open the door for a more bearish outlook:
- A sustained breakdown from key moving averages (first chart of the report)
- A head and shoulders pattern
A couple of pointers about oil’s potential head and shoulders pattern:
- Still needs to be confirmed with a breakdown of key support between $65 and $70
- It has a measured target of $35, an outcome we’d only envision in a recession
Middle-East Geopolitics Remain a Tail Risk for an Oil Melt-Up
The Israel-Hamas war hasn’t yet led to a breakout in oil prices:
- Oil investors are getting more worried about falling demand than geopolitical-driven supply concerns (demand tends to play a bigger role)
- The Israel-Hamas war is showing signs of de-escalating, but a regional war remains a possibility
China Stimulus Could Prove a Game-Changer
We’re monitoring for signs that the economy is turning around in China:
- Demand for credit remains weak, dragging global manufacturing activity
- We believe that fiscal stimulus is the most likely outcome to get the economy out of the hole
Credible stimulus that could snap consumers out of their entrenched pessimism and boost spending:
- Oil prices could break out and start a new bull market
- A strengthening China may offset worries of a U.S. recession dragging oil prices
Conclusion: Positioning for a Bull Market in Oil
Putting it all together, our playbook looks to time bearish near-term opportunities in oil with bullish longer-term ones driven by secular tailwinds.
While we’re bearish oil in the short-term, we’re more constructive in the long-run. We’d be looking to accumulate exposure to oil or energy stocks in the event that they become attractively-valued.
We believe a bull market in oil prices could develop in coming years driven by a couple of factors:
- There’s underinvestment in oil production, limiting future supply for the coming years
- China and India have runway to significantly boost demand over that timeframe
Slumping commodity prices in the last decade+ led to a collapse in the valuation of energy companies. That forced their executives to cut capital expenditures, leading to underinvestment.
China and India could play a big role in driving the next bull market in oil:
- An economic recovery in China driven by credible stimulus could see a long-lasting re-acceleration in oil demand
- India may accelerate industrialization efforts as urbanization picks up (a topic we’ll cover in more detail in future research)
