By Barani Krishnan
Investing.com -- How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?
It’s a question the late Federal Reserve legend Alan Greenspan raised in a landmark 1996 speech, just as the era’s dotcom bubble was starting to froth.
And it remains unanswered, James Dorn of the Cato Institute reflected in a recent blog, as the Fed races toward unwinding the Covid-triggered bond/mortgage asset buying it began two years ago and begins a higher interest rate regime that could last through 2024.
“What jumps out from Greenspan’s speech is how he posed a problem that the Fed never solved, and then made things worse,” observed Dorn. He cited the “Greenspan put” that had since become the Fed’s practice, as the central bank sought to manage one economic crisis after another with rate adjustments that never deflated the stock market itself.
In its aim to shield stocks - or at least not be blamed for their crash - the Fed also never quite achieved the inflation it desired. For a decade before the pandemic, it undershot its annual target of 2%. Now, it is overshooting it, with the Consumer Price Index growing by 7% in the year to December - its fastest in 40 years.
Within that inflation mix sits the 7-year high in oil prices, which rose as much as 6% for the just-ended week, after gains of around 11% in three previous weeks. For 2022 alone, U.S. crude is up 12% while global benchmark Brent shows an 11% rise.
The oil rally is, of course, a result of years of under-investment in new exploration and production, with the impact showing now as demand normalizes two years into the pandemic. On top of the shortage in new oil, there is also the deliberate squeeze on regular output by producer alliance OPEC+ which continues to withhold from the market an estimated four million barrels daily from cuts of some 10 million barrels per day carried out during the height of the Covid-triggered demand destruction. U.S. output, once the world’s largest with a pre-pandemic high of 13.1 million barrels daily, is now at under 12 million, thanks to unfriendly drilling policies of the Biden administration which wants renewable, green energy over fossils.
Last, but not least, oil prices are 60% higher now than a year ago because of the investment dollars gushing into crude in the name of inflation hedging.
And that’s where some of the irrational exuberance of investors sits. With Wall Street banks cheering hoarsely from the sidelines for $90-$100 oil, oil longs have thrown themselves headlong into the race to inflate crude prices as much as possible in the name of seeking a hedge from inflation itself.
As strong as the fundamentals are for the oil rally, the gains that have built over the past few weeks look frothy. If you’re long oil and foaming at the mouth as you read this - a sign of irrationality, no doubt - read on because this observation also comes from people who are typically bullish on crude.
“The rally in oil yesterday and today came on no-news and that's evidence of a squeeze on positioning,” Adam Button of ForexLive wrote in a Jan. 12 post after U.S. crude prices jumped 5.5% over a 48-hour period. Anyone who reads Button regularly will know he’s as ardent an oil bull as one could be. In that post, he reasoned that macro shorts in oil may be throwing in the towel as longs piled into the trade amid data suggesting that Covid’s Omicron may just have a fleeting impact on crude, regardless of the fears being built around the variant.
But Button worried about something else in his post - demand for fuel. His concern came after the U.S. Energy Information Administration reported earlier that day that gasoline stockpiles jumped by 7.96 million barrels in the latest week, overwhelming forecasts for a growth of 2.41 million. The latest build added to the previous week’s rise of 10.13-million barrels, which was already the largest weekly surge in gasoline stocks since the height of the coronavirus crisis in April 2020. EIA data also showed that gasoline inventories, as a whole, were up by a net of almost 30 million barrels over the past six weeks.
Inventories of distillates, which are refined into diesel for trucks, buses, trains and ships as well as fuel for jets, also swelled more than expected for a second week in a row, rising by 2.54 million barrels against a forecast of 1.76 million. In the previous week, distillate stocks grew by 4.42 million barrels.
To be fair, crude stockpiles fell too, dropping by 4.6 million barrels during the latest week, on top of the previous week's slide of 2.1 million. But in total, crude stockpiles fell by around 23 million barrels over the past six weeks, underwhelming the combined build in gasoline and distillates.
The slump in demand for gasoline came as the onset of winter reduced driving and the need to fill up auto tanks as much as during the recent holiday stretch. A surge in Omicron cases - whether people are dying of it or not - are also delaying plans by employers to bring workers back into offices, thus reducing commuting and other travel that requires fuel.
“Ultimately, this optimism will need to be reflected in demand,” Button wrote, referring to the optimism among the long-oil crowd pushing for $90-$100 oil.
Added Button:
“What I worry about is a sustained drop in Chinese demand due to Omicron. Much of the world has learned to carry on alongside the virus but more than 20 million people in China are currently in a hard lockdown. I expect that number to grow in the coming weeks and that's something that could severely hurt physical demand.”
“From where I stand, that's enough reason to sell oil and return to the sidelines near $85 in WTI.”
Not content with that, two days later, Button issued another post.
“The next step for oil will be a tough one,” he said in the follow-up. “A report today highlighted that China had agreed to release strategic oil reserves in different levels around Feb 1 depending on whether crude was at $75 or $85. With Brent at $86 and also mere cents away from the October high, the odds of more action rise.”
“At the same time, SPR releases are small amounts of oil overall,” Button said, referring to the Strategic Petroleum Reserves from both China and the United States that will start hitting the market over the next few weeks. “What we're seeing in jet fuel demand destruction and less driving should far outweigh that - yet it isn't. We've had back-to-back huge builds in U.S. gasoline supplies and the market has powered right through it. The buying is relentless.”
Phil Flynn, another avowed oil bull who’s energy analyst at Chicago’s Price Futures Group, also cited in a January note that China will soon release an unspecified amount of oil into the market depending on price levels.
"China agreed to release a relatively bigger amount if oil is above $85 a barrel, and a smaller volume if oil stays near the $75 level," Flynn said, citing a Reuters report. He noted that the release of crude stocks by China will occur around the Lunar New Year, according to the report. China will be closed for that celebration, which marks its biggest annual holiday, from Jan. 31 to Feb. 6.
Flynn also saw fit to mention that China's annual crude oil imports slid 5.4% in 2021, dropping for the first time since 2001, as Beijing clamped down on its refining sector to curb excess domestic fuel production while refiners drew down massive inventories. China has been the global oil demand driver for the last decade, accounting for 44% of worldwide growth in oil imports since 2015, when Beijing started issuing import quotas to independent refiners.
Neither Button nor Flynn are likely to become oil bears because of the balance they have tried to strike in their comments. They did so in recognition of some of the near-term market challenges facing oil longs, especially the growing resolve by China and the U.S. to fight back against inflation from oil. It’s called rational thinking - something that’s needed in oil now.
Crude Price & Technical Outlook
West Texas Intermediate, the benchmark for U.S. crude, settled Friday’s trade at $83.82 a barrel, up 2.1% on the day and 6.2% on the week.
London-traded Brent, the global benchmark for oil, settled at $86.06, up 1.9% on the day and 5.3% on the week.
Sunil Kumar Dixit, technical strategist at skcharting.com and a regular contributor of commodity technicals to Investing.com, said the prevailing bullish wave in oil may well advance WTI to $86.50 and, subsequently, $90.30 if prices hold firmly above 84 level.
“The weekly stochastic reading of 92/78 remains strong in favor of a further up move in U.S. crude,” said Dixit.
But he also cautioned that the bullish momentum will pause if prices break from their upward trend and close below $82.74 - a phenomenon likely should the narrative in oil change from the emergence of more bearish U.S. stockpiles data or the impact of the SPR releases.
“A daily close below $82.74 will expose WTI to $79.50 while a weekly close below this level is likely to trigger a correction to rebalance the parabolic rise in prices to $77.50 and the $75 areas,” he added.
Gold Market Activity Roundup
Gold had another high-wire balancing act, ending Friday’s trade down but the week higher.
More importantly, it recaptured the $1,800 level before the week’s close - a phenomenon broken only once in every weekly close of gold since the start of December.
The mixed close in gold came during a week when the yellow metal was caught between the two major U.S. datasets - the Consumer Price Index and retail sales.
Gold rose 0.5% after the CPI release on Wednesday, which showed that U.S. inflation jumped 7% in the year to December, its fastest rate since 1982.
But on Friday, the price dropped 0.3% after both the dollar and yields on the U.S. 10-year Treasury note crept higher as retail sales plummeted on consumers’ concerns about inflation - reinforcing the need for urgent rate hikes.
“Gold seems like it is in a good place as Treasury yields won’t be rallying much higher until at least a couple more Fed meetings” when the central bank announces its first pandemic-era interest rate hike, said Ed Moya, analyst at online trading platform OANDA.
The Fed dropped interest rates to virtually zero after the outbreak of the coronavirus pandemic in March 2020, keeping them at between zero and 0.25% over the past 20 months. The central bank’s officials have signaled that as many as four to five rate hikes may occur over the next year, with the first likely coming as early as March.
The U.S. economy shrank by 3.5% in 2020 due to shutdowns and other disruptions caused by the Covid-19 crisis. The Fed has projected a 5.5% growth for 2021 and 4% for 2022. The central bank’s problem though is inflation, running at four-decade highs as prices of almost everything have soared from the lows of the pandemic due to higher wage demands and supply chain disruptions.
Gold is touted as an inflation hedge and it is reinforcing that label by holding to the $1,800 level since the start of 2022. The yellow metal failed in its hedge mission several times last year as the dollar and U.S. Treasury yields rallied instead on expectations of U.S. rate hikes.
News of rate hikes is almost always bad for gold, which somewhat reflected this last year as it closed 2021 down 3.6% for its first annual dip in three years and the sharpest slump since 2015.
But analysts think that if the U.S. inflation theme remains strong through 2022, then gold could even retrace 2020’s record highs above $2,100 - a peak which, incidentally, came on the back of worries about price pressures as the United States began spending trillions of dollars on pandemic relief.
Gold Price & Technical Outlook
Gold futures’ most active contract on New York’s Comex, February, settled Friday’s trade down $4.90, or 0.3%, $1,816.50.
For the week, it rose 1.1%.
Dixit of skcharting.com said gold price action through the week showed the resolve of longs to reject bearish pressures after a test at the $1,782 level helped the yellow metal rebound to just short of the $1,830 resistance.
“While the rebound to $1,829 from $1,782 lows and weekly close at $1,817 does indicate bullish determination, failure to clear the decisive supply zone of $1830-$1835 casts a shadow of uncertainty,” Dixit said. “This raises the possibility of further downside, should the Dollar Index strengthen above the 95.25-95.55 levels and toward 95.85, fuelled by rising Treasury yields.”
He said the coming week’s outlook was mixed with more volatility foreseen.
Major moves will depend on traders' reaction to the $1,825 level, which is a 38.2% Fibonacci level, Dixit said.
“Consolidation above $1,825 will indicate further upside to test the $1,830-35 level required for the next leg higher at $1,860 (23.6% fibonacci level).”
“Weakness below $1,825 will start a correction to the 5-week Exponential Moving Average of $1,820 and the 10-week EMA of $1,806 extending to the weekly middle Bollinger Band of $1,795.”
Disclaimer: Barani Krishnan does not hold a position in the commodities and securities he writes about.