The oil price has fallen significantly over recent weeks. Having hit just over $126 per barrel in early June, Brent Crude has fallen back sharply to trade at below $100 this morning. Fears of recession and falling inflation expectations have weighed on the oil price. Key technical support is being tested. However, with supply constraints still an issue, the moves will continue to be volatile.
- Recession fears and falling inflation ushering oil lower. However, supply constraints may act as support moving forward.
- The futures curve is currently in “backwardation” where current prices are higher than future prices
- The technical outlook is testing the key medium-term range support
Recession fears and falling inflation expectations hit oil
In recent weeks we have seen a key switch in the outlook on bond markets. Suddenly, we see worries that the monetary policy tightening of major central banks, such as the Federal Reserve will feedback in negative growth.
Fears have been mounting that the aggressive Fed rate tightening will drive the US into recession. This is also linked to the expected inflation outlook sharply falling. Less demand in the future will weigh on inflation indicators. This all weighs on the outlook for oil.
We look at the 10-year US Breakeven Inflation for the outlook of expected inflation (where US inflation is expected to be in 10 years' time). This is falling. It is also falling just as Brent Crude oil is also falling. The two have a historically strongly positive correlation, which averages +0.41 over the past 12 months. The correlation is currently extremely strong at +0.80. If inflation expectations continue to fall, then this will weigh the oil price down too.
We see that the Brent Crude futures curve is currently in “backwardation”. This means that a barrel of oil bought at today’s spot price (c. $100) is higher than the price of locking in a barrel of oil in the months or years ahead. For oil delivery in July 2023 (12 months' time) you can lock in the price today at $85.50. This means that oil traders believe the price will be falling.
This may though produce a natural price stabiliser because it could encourage a restriction of oil production. Supply constraints are already an issue. OPEC+ are struggling to increase production to make up for the shortfall of Russian production. Also, the US has recently lowered its production growth forecasts in 2023, citing inflation and labor shortage issues.
Oil volatility remains elevated and is rising again
One thing for sure is that volatility remains high in the oil market. The CBOE Crude Oil Volatility Index (the equivalent of the VIX in equities, but for oil) has been elevated ever since the breakout of war in Ukraine. In 2021, volatility was around 35/40. Oil volatility has been rising since early June (coinciding with Brent Crude topping out at but has once more picked up in recent days and is pushing towards 50 again. This means that premiums are rising again and the cost of adding short protection is elevated (due to rising demand).
This suggests that the big swings in the oil price will likely continue to be a feature of trading, but also potentially with a bear bias (especially if volatility continues to rise).
Brent Crude testing key support
The technical analysis shows that Brent Crude oil (UKOUSD) has been trading in a broad range between $98/$126 since mid-March. However, a negative bias has developed in the past month.
Previously the corrections were finding lows on the RSI above 40 and moving up towards 60/65. However, we are now seeing deeper downside moves on RSI towards 30/35, whilst the bull rebounds are failing around 50. This is a classic negative configuration.
The reaction to the support around $98/$100 will be key now as the negative pressure has increased in the past week. A decisive close below $98 would be a key deterioration, especially if it was confirmed by the RSI moving below 30. This could then potentially open for a much deeper correction (a multi-month target of $70 could be argued).
However, until this big support is decisively broken, our base case is not for a big sell-off on oil. Given the volatility, supply issues and big swings seen over recent months, we favour selling strength towards $108/$110 resistance for further pressure on $98/$100. A move above $112 would neutralise the medium-term range once more.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorised to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
