What’s Causing the Oil Market’s “Weird” Reactions?

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The weekly oil inventory number released last Wednesday by the Energy Information Administration shows inventories grew by 3.9 million barrels over the previous week — faster than expected.

What's Causing the Oil Market's "Weird" Reactions?Although the reaction to this weekly data has historically been random, over the last six months, it has had a stronger correlation with short-term movements in the market.

We would expect an above-expectations report (like the one last week) to have a negative impact on oil prices and oil stocks. Similarly, a below-expectations build, or a decline, should have a positive impact on prices.

However, since the end of January, oil inventories have been rising with oil prices. Why?

There are a few possible explanations for the “weird” reaction in the oil market, and we suspect there are two major factors at play right now. Unfortunately, they are both likely to have a short-term impact on prices in the oil market.

China May Cut Production

Although most of the press has focused on the potential for the Organization of the Petroleum Exporting Countries (OPEC) and Russia to freeze production at January’s record levels, the world’s fourth-largest oil producer, China, may have to cut production independently. China’s production is consumed internally (they are also the world’s largest importer), so falling demand has already shown up in import prices.

It’s hard to argue that a rumor for production cuts in China is likely to have a material impact on the market that hasn’t already been priced in.

However, market realities haven’t had an immediate impact on price movements lately. Keep in mind (as shown in the chart below) that oil prices and oil stocks rallied on rumors of the OPEC “freeze” that won’t affect Iran’s output and would merely cap production in Saudi Arabia at all-time monthly records.

Investors are clearly very sensitive to the mere threat that a production cut may happen in the future. Historically speaking, this sort of issue tends to fade quickly once the “rumors” become the news.

xle_031116

Source: Chart Source — TradingView.com


A Short Squeeze by Institutions

A short squeeze occurs when a large number of traders have all shorted the same instrument and then have to unwind very quickly. Short positions are closed by buying back the stock or futures contract. A mass exit of short traders can have a dramatic impact on an asset.

A few years ago, Volkswagen was briefly the most valuable company in the world during a massive, days-long short squeeze.

In the oil market, there are two squeezes occurring at the same time. First, traders who shorted oil companies and the commodity itself are sensitive to eroding profits if prices bounce higher.

Second, institutions are extremely overweight on low-quality oil-company debt. Like they did with mortgage-backed securities (MBS) before the financial crisis, the big banks can push prices up a little higher by underwriting new offerings and foisting these bad assets onto their clients.

So far this year, oil companies have raised $9 billion in new offerings. The behavior of large institutions goes a long way to explain the weird rallies in stocks like Marathon Oil Corporation (MRO) and Pioneer Natural Resources (PXD).

A Silver Lining for Oil Market Bulls

Despite the fact that we expect the conflict between the fundamentals and oil prices to resolve in favor of lower prices, it may not hurt all energy companies. It may be time for the large refiners to profit again from a widening spread between oil and gasoline.

A small factor that may have helped contribute to a rise in oil prices today was a drawdown in gasoline inventories. Companies like Tesoro Corporation (TSO), Valero Energy Corporation (VLO) and Phillips 66 (PSX) may continue to move higher in the short term as lower oil prices motivate more drivers and car sales this summer.

There is no way to immunize the market from volatility in oil. Unfortunately this isn’t just an “earnings problem.”

It seems unlikely to us that the large financial institutions will be successful at boosting prices for bad debt for much longer. We expect the current rally to consolidate and decline like it did in the third quarter of last year.

Although this is frustrating for bulls, it would be a huge boost for option traders who are waiting for the breakout.

InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. To receive further instructions on this trade, get in on the next SlingShot Trader trade and receive 1 free month today by clicking here.

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