Many commodities like oil remain in a bearish supply cycle. This can help develop trading strategy, not only in commodities but in a range of index and currency markets as well.

Commodity super cycles

Commodity super cycles are part of the economic landscape. The concept is pretty simple. In most cases, it takes a long time and a lot of money to develop new production. In times of sharply rising demand, supply struggles to keep up. Supply deficits persist and prices push relentlessly higher. Eventually though, rising prices bring forward new sources of supply as higher cost production becomes profitable. There’s a tendency to overshoot. Producers become too confident about demand growth. Supply surpluses develop and prices are pushed relentlessly lower. Because investments are so large, producers are quick to cut back on new projects but are reluctant to mothball existing production. Several commodities are still in this phase. The long lags in developing new projects on the way up and the reluctance to mothball existing facilities on the way down, mean that commodity cycles have a tendency to last longer than most expect. This can be a useful observation for traders. Taking positions in the direction of the supply cycle can allow you to take advantage of the false starts and corrections that inevitably occur throughout the life of each cycle.

Oil market

The oil market serves as a good illustration of cycle dynamics. International Energy Agency (“IEA”) data shows that the world produced 96.5m barrels of oil a day in the June quarter but consumed only 93.5m. This 3m barrel surplus is the largest since 1998. At that time, the oil price was around $13 a barrel. The main contributor to the current surplus was the development of new shale oil technology. Opec famously responded to the increase in shale oil supplies by increasing its production to maintain market share. This saw price declines accelerate, hitting a low of $37.75 last month. It’s true there are now some green shoots emerging for the oil market. Despite sluggish economic growth, oil demand is picking up in response to lower prices. The IEA forecasts that world demand will grow by 1.6m barrels a day this year, compared to just 0.7m in 2014. At long last, we are also seeing signs of cuts to US shale oil production. By mid-September, average daily oil production in the US was 9.1m barrels compared to its peak of 9.6m in June. This is encouraging but there’s still a long way to go. The IEA estimates that it will take until late 2016 for this combination of demand growth and non Opec production cuts to bring the world market back into balance. Unfortunately, this analysis ignores Iran which is now the key swing factor for oil. Assuming trade sanctions are lifted, Iran is likely to put up to 1m barrels a day back onto world markets. This moves the prospect of balance well out into 2017. So unless there are major changes to the supply outlook, the surplus cycle looks as though it might favour a big picture theme of selling corrective rallies for a while yet.

US Crude Oil chart

These corrective rallies might be quite large of course and could happen quite quickly. Short term factors could easily see decent pops in a market that has more than halved in value over the past 15 months. Ultimately though, supply surpluses have a tendency to cap rallies and see downward price dynamics reasserted. Looking at the big picture monthly chart below which shows an Elliot 5 wave interpretation on the decline from $112.4 in mid-2013. Rallies up towards the last major peak at “4” or even to the 38.2% Fibonacci retracement around $66 might still be consistent with an ongoing supply surplus cycle. It will be a matter of using shorter term techniques to identify when corrective rallies might be coming to an end at or below these levels. Source: CMC Markets, September 2015

Other markets

In broad terms, weak commodity prices act like a pay cut for commodity exporters and a tax break for importers. It’s true that currency moves help offset this over time. However, while commodity surpluses persist, a strategy of using the indices and currencies of commodity exporters ( e.g. Australia, Canada, Russia) when selling rallies and those of importers ( e.g. Europe and Japan) when buying dips; may be another approach worth considering. Email: marketcomment@cmcmarkets.com Follow CMC Markets on Twitter: @cmcmarkets Follow Ric Spooner (Chief Market Analyst) on Twitter: @Ricspooner_CMC

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