Summer Surge: The Race to $111 Oil in July

Introduction: It is no mystery that looser financial conditions can bid up asset prices. In the last three months, there have been over 10 trillion dollars of appreciation across asset classes. Due to this wealth effect, we have seen an economic acceleration in firms' earnings and improvements in the service and manufacturing sectors.

For the most part, this is a positive development. However, there is considerable evidence that crude oil has just started a significant breakout. I will present a fundamental and technical case for a potential oil bull cycle in this piece.

Oil is a commodity that is not only highly sensitive to liquidity but also to geopolitical pressures. At this moment, there is a confluence of factors that show fundamental differences between this Q1 2024 rally in oil compared to Q3 2023.

The status quo involves a "no-landing" scenario in which parts of the economy are beginning to reaccelerate. The driver is not real economic growth but a response to the wealth effect. For now, we are in a scenario similar to 2021 where companies are able to take advantage of inflation and increase their bottom lines. In the short term, production costs are sticky, but heading into Q3, we are likely to see margin pressures. As of this moment, manufacturing has had its best recovery since June 2022, and overall, leading economic indicators are beginning to bottom; commodities are starting to follow suit.

Why is this different than Q3 2023? At that time, we were dealing with an FED that was not yet resolute on their direction on interest rates, while market participants had a base case that at some point in 2024, we would have a hard landing. As markets rallied with the dovish FED policy shift in October, financial assets rose rapidly, which boosted consumer confidence. Now, the base case is that earnings revisions are to the upside and, rather than experiencing disinflation, are experiencing inflation. GS's commodity basket has rallied over 17% YTD, showing a significantly broader participation than last year's rally. One of the biggest warning signals for an oil breakout and economic reacceleration is the price of Copper.

With that narrative in mind, I will present the objective substance by providing an in-depth technical oil analysis and then make a case for a $XLE rotation in July.

WTI Crude Oil Futures Macro View:

In March of this year, we experienced a technical phenomenon known as coiling. This is when prices go sideways within a structure and eventually break out or break down. In this case, the resumption was to the upside, and we invalidated the resistance trendline that was of material resistance from the start of the Russia/Ukraine invasion to the prior top we formed in Q3 2023.

This means a new bullish resolution has begun, and Oil will likely test prior highs. Using a Fibonacci extension tool based on the prior high and the current December 2023 low, this extension could take us upwards of $111.99/bbl.

Crack Spreads:

Crack spreads are also a good forecaster of where oil prices are going. By taking account of the cost of converting crude oil to gasoline, we can get an insight into the general demand. RBOB crack spreads are set to start their first positive week above the middle Bollinger band since January 2022. The middle Bollinger band is an excellent indicator to consider for a change in trend. From a fundamental standpoint, this is relevant going into the summer cycle, where seasonality is strong, and consumers are likely to travel more and spend money on leisure in hospitality. In last year's rally, crack spreads weren't supportive of the price of crude and overall demonstrated a negative divergence from that rally.

WTI Crude Oil Futures Monthly:

In the monthly view for crude, we can see that oil is on track for confirmation above the middle Bollinger band. Additionally, we will likely get the first positive monthly MACD cross since early 2021. In the past, the combination of these indicators from a monthly view has been consistent with the trade direction afterward. If crude continues to break out, it will need confirmation from these signals.

WTI Crude Oil Futures Short Term View:

In the short term, crude oil faces considerable overhead resistance. We have just achieved the 1.618 fib extension from the inverse heads and shoulders neckline breakout. The most significant area of resistance is currently between $88.69-89.75. Within this area, we have daily supplies (zones of liquidity) where prior sellers are likely to defend their position. Furthermore, this aligns with the 0.786 fib retracement from the prior Q3 high to our December low. The OVX (Crude Oil Volatility Index) has negative divergences in relation to Crude and is warning us that in the coming sessions, Crude is likely to sell off. Considering prior corrections in 2024, such a correction could vary between 6-9%. Corrections are expected to be short-lived, and there's strong support between $80.84-80.31

$XLE Macro view:

The big-picture view for the $XLE is a substantial breakout from current levels. The fundamental case is simple: companies have significantly reduced their debt levels and have been focusing on enhancing shareholder returns. The oil industry is historically cyclical, but it has been extraordinarily resilient in this current cycle. We believe it warrants a multiple expansion as oil prices will likely stay higher for longer.

Looking at individual companies, most analysts currently forecast crude oil between Q2 and Q3 2024 at between $73 and $82/bbl. According to our proprietary models, we expect EPS for this sector to be at least 24% higher than expected.

Returning to this $XLE chart, this measured breakout could take us to the fib 1.618 extension to a high of $150.40. Note that the time horizon to reach this target would be measured in months to years.

$XLE Short Term View:

This chart is from MenthorQ, which provides the most insightful data on options. According to the current gamma exposure, considerable open interest is being built at the $100 strike level. This level should be seen as a magnet, and a break above it could take us upwards of $105. When we look at the options matrix, around 36% of positive delta and gamma exposure is set to expire by July. Until then, flows will likely be positive if gamma is in a positive regiment.

Considering options, OTM calls for Brent and Crude are catching bids. According to the term structure, the convexity is to the upside.

Final Thoughts:

As of now, there is substantial evidence to be bullish on oil. We are entering a period of positive seasonality, crack spreads are widening, and geopolitical risk is increasing. Looking forward, a continuation of an oil rally will be contingent on the economy's health and the outcome of the 2024 presidential election.

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