A so-called volatility squeeze in commodity indexes that I have been referring to resolved itself to the downside last week, with crude oil leading the way in what should be a seasonally strong period for the high-octane commodity.
Volatility squeezes typically tend to resolve themselves in the direction of the major trend. We had a similar volatility squeeze in the S&P 500 SPX, +0.09% which resolved itself to the upside in the direction of the major trend. (Please see my Jan. 20 column, “I’m expecting a stock market rally this year, but 2018 is another matter.”) Now we have a similar resolution from commodity indexes in the direction of the major trend — to the downside. This is why traders like to say: “The trend is your friend.”
Another surprise here is that crude oil did not decline in the seasonally weak September-to-February period, and now it is weakening right around the time when it bottomed out and was beginning to rebound in early 2015 and early 2016. This is peculiar, as we have a recent OPEC deal to cut production that may have helped oil stay up in a seasonally weak period, but clearly is not helping it at the moment.
The oil market is flipping back deeper into “contango,” where the near-term futures contracts are cheaper and the longer-dated contracts are more expensive. Oil producers would prefer to see “backwardation” in the futures curve — which is the reverse of contango, a situation where the near-term futures contracts are more expensive and they get cheaper progressively into the future as backwardation maximizes revenues for producers.
Deepening contango in the oil market simply means increasing oversupply. Deepening contango as we enter the supposedly strong season for oil prices (March to September) is not a good sign, as the market is doing the opposite of what seasonality suggests. As I like to say in such situations, if the market does not do what you think it should do, there is a message in that, too.
Another surprise here is that oil was down on news of the February employment report, which was rather strong. This caused a sell-off in the U.S. dollar, which typically helps energy and metals, but not this time. There was clear selling into strength in crude oil futures as April WTI futures CLJ7, -0.33% rose briefly above $50/barrel when February non-farm payrolls were announced but ended dripping down all day to close the day and the week at $48.48. In Shakespearean terms, I’d say “something is rotten in the state of the oil markets.”
It was not only oil. Most economically sensitive commodities fell, if one runs through all the components of the CRB index. What could be doing this to crude oil and other major commodities?
The two major risks to commodities and the global economy are the Chinese credit bubble and the difficult-to-quantify political risk in Europe with the region’s heavy election cycle in 2017. While European elections are front-page news, China isn’t like it was in early 2016, when malfunctioning circuit breakers on mainland stock exchanges caused a rather large sell-off in global markets in credit, equities and commodities.
The Chinese market has not yet been able to recover what it lost in January 2016. If one wanted to find a perfect illustration for the rather nebulous trading term “dead-cat bounce,” this chart action in the Shanghai Composite — since it found a bottom in late January 2016 — fits the bill to a T.
I am sure that there is a problem with the Chinese economy that has not fully surfaced yet. The crash in the Chinese stock market in 2015 is only part of that problem. The rapid (11-fold) growth of the Chinese economy since the year 2000 was fueled by excessive borrowing, which raised the total leverage ratio in the Chinese economy from 100% of GDP to about 400%, if one includes the infamous unregulated shadow banking system.
That’s more than a 40-fold rise in total credit aggregates. It is this shadow banking system that is to blame for the excessive margin leverage that resulted in the 2015 crash in the Shanghai Composite. This hyper-economic growth based on hyper-credit growth and the resulting recent economic slowdown crashed the commodity markets in 2014, then it crashed the mainland stock exchanges in 2015 and it may very well crash the entire Chinese economy next. (See my Feb. 20 column, “China’s economy is dangerously close to unraveling.”)
Whether China’s economic crash will come in 2017 or not, I do not know. But I am taking official Chinese economic releases with more than a grain of salt, knowing the situation in the country’s credit markets and the fact that it’s famous for doctoring statistics. Considering the fact that China is the No. 1 consumer of oil, it is not that far-fetched to look East for an explanation for the recent peculiar oil price weakness. While economic releases can be fudged, it is much more difficult to mess with the direction of the Shanghai Composite or the level of crude oil prices, none of which are acting too perky at the moment.
Over the past week, I saw quite a few explanations for the recent oil price weakness — being due to the surge in U.S. rig count and shale production — which is to be expected, as there was massive borrowing in the U.S. oil sector in the past 10 years, and those high debts need to be serviced. I also saw quite a few stories about how the Chinese economy is slowly improving, which, frankly, I do not believe. Something is rotten in the state of the oil markets and my gut feeling tells me that one of the rather significant factors is China.