Oil traders are still shell-shocked by prices turning negative on Monday
Beware of trying to catch a falling knife
Monday, the 21st of April of 2020, will most certainly enter the oil-trading history books.
What unfolded on the market for the May crude futures contract, which is set to expire at the end of the trading day today, demonstrated how misunderstood financial markets are. The price of the contract dropped to more than $40 below zero and settled at minus $37.63 when the market closed.
This price action was so unexpected, that it will, beyond doubt, enter the economic history books as a black swan event, which is used to describe an extraordinary or unlikely episode. While negative prices occurred only for the May futures contract, which expires today, there is no guarantee that the June contract will be any different a month from now. Cash prices for West Texas Intermediate, or WTI, oil are currently at $18.81 in the run-up to the New York open. This is again bound to be another crazy trading day.
WTI oil prices have broken out below every concievable bottom that we can pick on the monthly chart. The intensity of the downside move propmts a careful reasessment of the direction of the next major move. While bottom pickers continue to lick their wounds, it is worth exploring what rules traders must remember when positioning themselves in such a volatile market.
In his world-famous book - which every trader must read at least once, I must add - Reminiscences of a Stock Operator, Edwin Lefèvre recounts the experience of Jesse Livermore, one of the most successful traders in history, and at one point, the richest man in the world.
“Stocks are never too high to buy or too low to sell,” he said in the book. A key mistake that retail traders make, especially in the beginning, when they are getting to know the markets, is that they trust that sooner or later the market reverses from a trend move. Yesterday’s price action in oil served as a crucial reminder of this rule and how much it applies to any asset you’re trading.
Common sense dictates that the price of oil is not zero and be certain that at some point sooner or later, it will rebound. The timing of the move, however, is critical. Just 20 minutes after I wrote the sentence that oil price is currently trading at $18.81, it is right now at $17.09. The takeaway is: beware of trying to catch a falling knife.
Supply and demand are everything
The only thing that can stop the massive decline in oil prices is a return of demand, and let’s face it, we have no idea when things will go back to normal. There is simply too much oil that has been already extracted from the ground across the globe. Meanwhile, supply remains ample, despite the best efforts on of OPEC, or Organization of the Petroleum Exporting Countries, and other oil producing nations that agreed the biggest coordinated production cuts in history earlier in April.
There are two scenarios that will make oil prices go higher - demand returns, or we hear about more supply cuts being mulled by oil producing nations. Until then, storage capacity in the U.S. is full, and traders who are holding WTI futures contracts until the very last day of the contract’s term, will have to take delivery of 1,000 barrels of oil the next month. The costs associated with taking delivery and storing the commodity are so substantial that traders are ready to pay anyone who is willing to rid them of the contractual obligation.
Suddenly, nobody needs oil, and no one knows when consumption patterns will return to normal - let alone knowing what the new normal will be like. Until some form of clarity comes back to the supply/demand ratio, it’s safe to say that it’s more likely for oil to continue to trade lower, rather than higher.
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