Why Oil Prices Will Keep Falling

As you will be well aware if you are a regular reader of my musings here and elsewhere, I generally favor a contrarian trading style. That comes from years spent in the interbank forex market, where the intraday nature of most desks’ trading meant that trades became very crowded very quickly. Once a move got underway and gained momentum, it wasn’t long before nearly everyone was positioned the same way, a situation that skewed the risk/reward against that direction. If everyone is short, there are few left to sell, and even a small move up can induce a panicked rush for the exit…a classic short squeeze. And the same could happen the other way around too if everyone was a buyer.

Oil, though, is not forex.

In a forex trade, when you are short one currency, you are inevitably long the currency on the other side of the trade. If you buy USD/JPY, say, you go long dollars, but you simultaneously go short the yen that you bought those dollars with. That means that, at some point, you have to cover that short and square up. With oil, though, one side of the trade is a commodity…it can be used and consumed, and it is subject to supply and demand fluctuations. If economic conditions are bad and demand is falling, say, suppliers still need to sell their production, and will do so at ever lower levels rather than leave themselves with a big storage problem.

That means that moves can be sustained longer, and because of current conditions, we look to be in one of those big, sustainable moves now that constitutes a fundamental reset in price. We are, after all, in the midst of a fundamental reset in conditions. On Thursday morning, the ECB joined the Fed in the 75 basis point club when they announced a three-quarter point rate hike, the biggest in the history of that institution.

Central banks are determined to choke growth in order to fight off inflation and have said loud and clear that they won’t stop hiking rates until the data show that they have succeeded. That sounds noble and determined, but when you consider that the data points they are talking about are all at least one month out of date when they are released and that the Fed and ECB typically rely on a three-month moving average of that old information , there is an obvious problem. By the time they stop hiking rates they will probably have forced Europe and the US, and therefore almost inevitably the world, into a recession.

That is why, even though the chart for WTI futures (CL) has a look that would often have me seeking a bottom, I am doing no such thing; in fact, I am still trading with a distinct short bias.

For those unfamiliar with that phrase, it doesn’t mean that I am short all the time, nor that I never take a long intraday position. What it does mean though is that when I do go long, I put quite tight stop losses in place and, win or lose, always cut the position before the day is out. Profit targets on longs are closer than normal too, and when they are hit, I am out, no matter the momentum level or other factors that might sometime make me readjust stops and run the position. Shorts, however, have looser stops and more chance of being left overnight, with a stop reset and partial cut at most being the normal response to hitting a target level.

There has been a big move down in crude since the beginning of June, the kind of move that usually piques the interest of the contrarian in me. Not now, though. The World’s central banks are actively trying to slow economies and the way they are going about it makes it likely they will go too far, making further losses in oil prices much more likely than any kind of turnaround.