Markets constantly provide valuable information. But it’s up to us to listen.
Of course, it’s easy to get caught in a narrative or bias surrounding a particular market. It’s part of the human condition.
And it’s almost a prerequisite.
In order to step up to the line and assume risk, we need to have a certain level of conviction. At the same time, we must remain open-minded and flexible, willing to receive new information and update our priors.
It’s a balancing act.
And energy is one area of the commodity market that’s keeping us on our toes.
Heading into Q3, we were looking for energy to follow the vast majority of other commodities lower, including base and industrial metals.
So far, that hasn’t been the case.
The chart below highlights how closely the two procyclical commodities groups have trailed each other heading into 2022:
This relationship began to decouple in March, as base and industrial metals peaked and started turning lower.
At the same time, energy contracts went on to make fresh highs into June, while most commodities experienced a steep correction.
Was energy just the last man standing? That was a big question at the start of the second half.
The weight of the evidence suggested crude oil and the gang were next, as sellers were coming out in full force.
But it’s almost two months later, and we've yet to witness any significant downside follow-through from energy contracts.
Instead, what we’re seeing is incredible resilience from these commodities and their related stocks.
Here’s a triple-pane chart of Oil Services $OIH, Explorers and Producers $XOP, and Oil Refiners $CRAK:
The tactical trend for these industry groups is sideways with a downward tilt.
Well, it’s been two weeks. And these stocks continue to dig in and catch higher. OIH and CRAK are retesting their 2021 highs from below, while XOP breaks to fresh multi-month highs.
This is the opposite of bearish. When an asset has every reason to go down, and it doesn’t, that’s some of the best information.
And we’re listening.
Yes, the bias is still sideways as long as they’re stuck below overhead supply. But so much for that "downward tilt." The data is changing, and we’re changing with it.
The crack spread is another piece of evidence that's turning around:
After a dramatic tightening last month, the spread has stopped going down. Now we're seeing it start to widen again.
This is a bullish development as a larger crack spread indicates underlying demand for crude oil derivatives such as heating oil and gasoline.
The strong demand for these distillates flows down to crude and oil refining stocks. It also means higher profits for these companies if that's something you're into.
It’s no wonder that CRAK and crude oil futures have been so buoyant.
And that brings us to a chart of crude oil:
Supply recently overwhelmed demand as crude broke support on its way to fresh six-month lows. We got short on the daily close below 94.25 based on the setup we outlined last month. But downside follow-through is lacking.
Every day it holds above its October pivot highs near 85.50 is a day I don’t want to be short crude oil.
On the flip side, I’m not ready to get long until a daily close back above our risk level.
That sums up my take on crude. I’m not crazy about staying short with the gnawing possibility that we have a potential failed breakdown on our hands. And I'm not ready to get long.
Some of the best signals are when markets don’t do what you expect them to.
For instance, when head and shoulders patterns fail or extension levels are completely ignored by price. In this case, we have a breakdown that refuses to break down!
That’s the market conveying critical information. Now, it’s up to us to accept it even if it challenges our priors.
As the legendary trader Peter Brandt puts it, we must have strong opinions, weakly held.
I like that.
COT Heatmap Highlights
Commercial hedgers slightly reduced their long exposure to crude oil by 3,070 contracts.
Commercials like cocoa. They're less than 5% away from their largest long position in three years.
And commercials continue to hover near three-year net long extremes in lumber.
