Back on July 15th, we wrote that the forward curve of futures markets can be very instructive to market participants in their decision process. In our note, we pointed out that the front-month contract for August delivery of WTI crude oil was priced at $73.84, but in addition, we noted as well that the forward prices were in a clear discount to the front month and that the market was in a steep “backwardation”. We also discussed how this was a clear indication that the market did not agree with some analysts' calls for $100.00 WTI crude prices in the near future. We pointed out that the prices in multiple contracts going out two years were in sequential decline to August of 2023 which was priced at $60.71, a significant discount of $13.13 to the August 2021 price. That did not argue for $100 dollar oil; it argued otherwise.
So, what have been the news drivers and what has the market done in the three weeks’ time since? Well, COVID-19 Delta news has increased, especially over the last week or so in the United States, Europe, and Asia. Goldman Sachs was reported to have slashed its forecasted GDP growth rate for China. As a result, prices for commodities in general and WTI crude oil, in particular, have declined. As of this writing (Monday the 9th of August), the new front month is September delivery and WTI crude is quoted at $66.41 a barrel, and two years out is quoted at $57.24. Thus in about 3 weeks’ time, front-month oil has dropped $7.43 or -10.06%. In addition, we note that delivery out two years to September 2023 (adjusting for the roll from August to September) has moved down approximately 3 and a half dollars. Now what one might infer is that a narrowing backwardation (in this case from $13.13 going to about $ 9.17) might be bullish, but in general, it is not bullish initially and is indicative of lower prices to come.
The Energy Service Sector as measured by the S&P 500 (XLE) spyder has declined from $50.1 to $48.68 or -2.8% during the past 3 weeks. On the surface, one would surmise that it is a somewhat inconsequential decline considering the decline in oil itself, but beneath the surface, there is more to the story. Many of the stocks that are highly levered to the price of oil and gas in the energy sector had been in a decline for a few weeks ahead of the decline in the price of oil. Some of those stocks have held up quite nicely since our July 15 blog entry and on a relative strength basis have outperformed the commodity. So although the narrowing term structure in the forward oil prices argues for continued short-term weakness in WTI crude oil, the stocks that are levered to the price of oil have begun to stabilize. And now we see what appears to be the beginnings of a bullish divergence. Should the pandemic news start to abate the energy sector may begin to outperform the rest of the market once again. Stay wary and stay safe.
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