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The Smart Money Is Still Betting Against Crude Oil

Jesse Colombo

Crude oil prices have remained relatively calm since their 25 percent late-August spike thanks to U.S. dollar weakness and reduced expectations of Fed rate hikes. As a result, many investors are wondering if the bottom is in for crude oil and energy stocks and whether it's a good time to look for bargains. Ever since warning about the oil bust in June 2014, I have also been trying to determine where the bottom is for crude oil. Despite investors' hopes, the fundamentals of the crude oil market have not changed much since the start of the year.

From a technical standpoint, WTI crude oil is sitting under a major resistance zone from $50 to $52 per barrel that needs to be broken to give another bullish signal. If WTI crude is unable to break above that resistance zone and weakens again, $40 is the next major support level to watch. A convincing break below $40 would lead to another bearish signal.

WTIDaily

Source: Barchart.com

Like WTI, Brent crude oil is beneath an important resistance zone from $55 to $60 per barrel that needs to be cleared in order to give a bullish signal. If Brent proves unable to break above that resistance and heads lower, $45 is the next major support level to keep an eye on.

BrentDaily

Source: Barchart.com

The longer-term WTI crude oil chart shows how important the $40 per barrel support level is. This level marked the peak of the first Gulf War oil panic in 1990 and acted as a key psychological support during the 2009 oil crash. This $40 support level was tested in late-August before crude oil rebounded 25 percent in just a few days. This support level needs to hold in order for a convincing crude oil bottom to form. A strong break below $40, however, could see prices hit $30, $20, or even lower, as some analysts have been warning. WTI is still below its uptrend line that started in 1999; a break back above this level would be a bullish confirmation.

WTIMonthly

Source: Barchart.com

$40 is also an important psychological level in Brent crude oil that needs to hold in order for a convincing bottom to form. A vigorous break below this level would give another bearish signal. As with WTI crude, Brent is beneath its uptrend line that started in 1999; a break back above this level would be a bullish confirmation.

BrentMonthly

Source: Barchart.com

Commercial crude oil futures hedgers (often considered the "smart money") have used the rally of the past two months to add to their sizable net-short position, while the large traders (the "dumb money") have added to their net-long position. The commercial hedgers' aggressive short position shows that they are still skeptical of any rebound in crude oil prices for the time being, while the large traders' long position shows that there hasn't yet been a true capitulation or liquidation that typically signals a genuine market bottom.

COTDaily

Source: Finviz.com

The longer-term chart shows how both commercial hedgers and large traders had flat positions in WTI crude oil as recently as 2010.

CTOWeekly

Source: Finviz.com

The U.S. dollar plays a significant role in the direction of crude oil prices, but it has been treading water since the beginning of this year as it forms a wedge pattern. The dollar’s eventual breakout from this pattern (bullish or bearish) should strongly influence crude oil's next major move. Due to their inverse relationship, a bullish dollar breakout would be bearish for crude oil, while a bearish dollar breakdown would be bullish for crude oil. The dollar's powerful 2014 bull market was one of the main reasons why crude oil experienced a bust.

DollarWeekly

Source: Barchart.com

The dollar has eased in the past several months as investors lower their expectations of an imminent Fed rate hike, but has been supported by the specter of further stimulus from Bank of Japan and the European Central Bank as those economies flirt with deflation once again. Additional stimulus in Japan and Europe (especially if combined) is an important potential bullish factor for the U.S. dollar, even if the U.S. economy continues to stagnate and Fed Funds rate hikes are pushed off even further into the future.

The crude oil glut - a major bearish factor since summer 2014 - continues to persist and is growing worse again after showing signs of improving this spring. According to the EIA petroleum status report, inventories surged by an unexpected 7.6 million barrels in the week of October 9th to 468.6 million barrels. Moody's recently adjusted its oil price forecast downward and warned that steady U.S. oil production will continue to keep a lid on prices in the next few years. In addition, Goldman Sachs expressed its skepticism toward the recent oil rebound, saying that the bounce was mostly driven by speculators and that the oil market will remain "oversupplied" into 2016.

Inventories

Source: Econoday/Haver Analytics

For now, traders should watch how WTI and Brent crude oil act at their key support and resistance levels shown in this piece. In addition, all eyes should be on the dollar to see how it breaks out of its 2015 consolidation pattern. Crude oil moves that aren't confirmed by similar moves in the U.S. dollar should be viewed with more suspicion than those that are confirmed by the dollar.

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(Disclaimer: All information is provided for educational purposes only and should not be relied on for making any investment decisions. These chart analysis blog posts are simply market “play by plays” and color commentaries, not hard predictions, as the author is an agnostic on short-term market movements.)