Funds run for cover as oil breaks 3-month stalemate

952980Ole Hansen –

Crude oil was added to the growing list of commodity casualties this week as market jitters ahead of next week’s Federal Reserve meeting continued.
The Federal Open Market Committee is widely expected to give the Fed funds rate another 25 basis point notch to the upside when it meets on March 15.
This, combined with strong US data, has triggered a dollar rally, not least against emerging market currencies. US bond yields, meanwhile, continue to surge higher with 10-year government yields reaching their highest level since December 15.
The Bloomberg commodity index — which reflects the performance of key commodities split into energy, metals and agriculture — dropped to a 3½-month low. The losses were broad-based with losses seen across all sectors. The weekly updates on speculative positions held by funds have shown a major build up in bullish commodity bets during the past year.
The trend only accelerated following both the US election and the Opec production cut agreement back in November.
The fact that the Bloomberg Commodity index has been trading sideways for almost a year did not dissuade this build in speculative bets, particularly in oil, gold, silver, copper, soybeans and sugar. With some of the drivers behind this buying activity showing signs of fading, these commodities in particular have been left exposed to long liquidation with funds adjusting risk to a less bullish scenario.
Apart from the focus on the US and the by now priced-in rate hike, the commodity sector as a whole has been battling with supply news recently.
The price of oil finally broke its three-month stalemate and sold off following another strong US inventory build. Copper was sold in response to a rapid increase in LME inventories while soybeans and corn reacted negatively to news about a bumper crop in Brazil.
Corn and especially soybeans, a favourite among hedge funds looking for bullish agriculture exposure, hit a two-month low following the monthly WASDE report from the USDA. It was the bigger-than-expected upgrade to its estimates for Brazil’s production of both crops in 2016-17 which caused the price damage. These developments led the USDA to reduce its forecast for US soybean exports, hence the sell-off.
Wheat did better with a rise in global supply being offset by forecast of strong demand; it was primarily dragged lower by the losses seen in corn and soybeans.
Precious metals led by silver had another horrid week with the technical outlook deteriorating further. Several key levels of support were broken as the market once took fright ahead of a US rate decision. The dollar has risen but it has been the jump in bond yields that most notably helped remove some of the recent strong support.
Whether we are going to see a repeat very much depends on the continued trajectory of stocks, bonds, and the dollar. The yield on US 10-year bonds is challenging the December 15 high at 2.61 per cent and a break could open up for a move towards 3 per cent. With inflation breakevens staying close to 2 per cent. Such a move could trigger another leg up in the real yield thereby creating further headwind for non-coupon and interest paying metals.
While gold only turned lower on February 27 after failing to break its 200-day moving average at $1,262/oz mining stocks had already shown weakness almost three weeks earlier. The VanEck Vectors Gold Miners EFT, which tracks mining stocks across the world, peaked on February 8 despite the tailwind from gold still moving higher.
This highlights that when it comes to determine the direction of a market, all aspects have to be taken into consideration.
The last two times the Federal Open Market Committee raised rates, gold reacted negatively in the run-up to the announcement only to rally afterwards.
In December 2015, gold lost 2 per cent during the month leading up to the hike only to rally by 2.6 per cent the following month. The before-and-after reaction to December 2016 was a drop of 5 per cent (with Trump’s election win playing its part) followed by a 3.4 per cent rally.
The July to December sell-off last year was only halted once gold had corrected 76.4 per cent of the prior rally. The current weakness in gold has seen it retrace almost half of the December-to-February rally. Given the current focus on rising yields, a deeper correction could see it test $1176, the January correction low.
We are back to neutral but have yet to change our longer term outlook which favours higher prices.
Crude “finally” broke its narrowing range this week and not surprisingly to us, it was the downside that caved. The ninth consecutive weekly rise in US stocks to a new record was driven by rising imports from Opec — Saudi Arabia, in fact, shipped the most oil to the US since August 2016.
For whatever reason, this is the wrong signal to send considering the intense market focus on the weekly EIA report which is often being used as a gauge to the global market.
US crude oil inventories hit a new record of 528 million barrels with imports not yet showing any signs of slowing as a result of Opec production cuts. Exports from Saudi Arabia, Iraq, Kuwait and Ecuador even rose by almost 900,000 barrels/day last week. Adding additional pressure to Opec’s effort to rebalance the market are rising US exports, which are only expected to grow because of rising production in Texas.
Crude oil has now stabilised following a two-day rout which saw it eventually find support at the critical $48.70/b level. Three lines of support merges around this level (see the chart below) with a failure to hold signalling another downside extension. The market remains heavy but some consolidation can be expected with resistance at $50.70/b coming into focus.
[Ole Hansen is head of commodity strategy at Saxo Bank]