[This blog post is a modified excerpt from a commentary published at TSI about two weeks ago. We've updated the charts and prices to reflect the current market situation.]

Today we’ll take a brief look at oil through three different lenses: The long-term price-action lens, the physical supply-demand lens and the macro-economic lens.

The following chart shows the significance of the US$76-$77 price level above which oil has moved over the past few weeks. This price level acted as support during large downward corrections in 2011-2012 and capped the 2016-2018 rally.

The move above major resistance is not a short-term buy signal, because the market is ‘overbought’ (which, by the way, doesn’t guarantee that the price will fall, but does mean that the risk of new buying is relatively high). However, it is a reward for those who added to their oil exposure when the commodity and the related equities were ‘oversold’ at various times over the past three months and is consistent with our view that the cyclical advance will extend into 2022.

With regard to likely future performance, of far greater importance than the break above long-term resistance is that the physical supply situation remains unusually ‘tight’. We know this is the case because strong backwardation (meaning: nearer-dated contracts are priced well above later-dated contracts) prevails in the oil futures market. This is evidenced by the downward slope on the following chart. Strong backwardation can only arise and be sustained in the oil market during a period when the demand for oil is high relative to the currently available supply.

The most recent data on the following chart is for the situation at 14th October 2021, but the futures curve continues to have a steep downward slope. For example, at the time of writing oil for delivery in December of this year is priced at $84.55, whereas oil for delivery in December-2022 is priced at $72.58 and oil for delivery in December-2023 is priced at only $66.56.

Note that the prices of oil futures are NOT forecasts of where the spot price will be in the future. Instead, the futures price relative to the spot price reflects the cost of storage. Since the cost of storage is always above zero, the futures price will always be higher than the spot price unless there is a current shortage of the physical commodity.

Chart source: https://www.erce.energy/graph/wti-futures-curve/

Our last chart shows that the oil price and the Inflation Expectations ETF (RINF) usually trend in the same direction. This positive correlation is part and parcel of a broader positive correlation between commodity prices (as represented by indices such as GNX) and inflation expectations.

Both oil and inflation expectations have resumed their cyclical upswings following corrections during the second and third quarters of this year.

At the moment, the price action, the supply-demand fundamentals and the macro-economic backdrop (as reflected by inflation expectations) are saying the same thing. They are all saying that we should expect the oil price to continue its upward trend.

[This blog post is a brief excerpt from a recent TSI commentary]

The latest leading economic data indicate that the US recovery/expansion is intact and that US GDP will continue to grow at an above-average rate for at least two more quarters, albeit not as quickly as it grew during the first half of this year. Of particular relevance, the following monthly chart shows that the ISM Manufacturing New Orders Index (NOI), one of our favourite leading economic indicators, remains near the top of its 20-year range. The ISM NOI leads Industrial Production by 3-6 months.

Note that the GDP growth number for Q3-2021, the preliminary calculation of which will be reported late this month, could reveal substantial deceleration from the 6%-7% growth that was reported for the first two quarters of this year. In fact, it could be as low as 2%. However, the financial markets are aware of this and went at least part of the way towards discounting the slowdown over the past few months. More importantly, there’s a good chance that US economic activity will re-accelerate late this year and into the first quarter of next year. This will be partly due to inventory building but mainly due to millions of people re-entering the workforce (millions of people who were paid by the government NOT to produce are going to become productive due to the expiry, early last month, of the federal government’s $300/week unemployment subsidy).

The performances of leading and coincident economic indicators show that the US economy remains in the boom phase of the boom-bust cycle, meaning that the economic landscape remains bullish for industrial commodities relative to gold. Consequently, the major upward trend in the commodity/gold ratio (GNX/gold) evident on the following chart should extend into next year.

In conclusion and as stated in previous commentaries over the past few months, the probability of the US economy re-entering recession territory prior to mid-2022 is extremely low, although current money-supply trends warn that a boom-to-bust transition and an equity bear market could begin as soon as the first half of 2022. This would suggest the second half of 2022 for the start of the next US recession, but there’s no point trying to look that far ahead. Our favourite leading indicators should give us ample warning.

There are two things that always happen at or prior to the start of a boom-to-bust transition for the US economy. One is a clear-cut widening of credit spreads and the other is pronounced weakness in the Industrial Metals Index (GYX) relative to the gold price. These indicators have sometimes warned incorrectly that a bust was about to begin, but they have never failed to signal an actual boom-to-bust transition in a timely manner. Below are charts showing the current positions of these reliable boom-bust indicators.

The first chart shows the US High Yield Index Option-Adjusted Spread (HYIOAS), a good indicator of US credit spreads.

In early-July of this year the HYIOAS was at its lowest level in more than 10 years and not far from an all-time low. It spiked upward around the middle of July, but it has since returned to near its low. This means that credit spreads in the US remain close to their narrowest levels ever.

Note that a credit-spread reversal would be signalled by the HYIOAS making a higher short-term high AND moving back above 4%. The first of these criteria (the initial warning) would be triggered by a move above 3.5%.

The next chart shows the GYX/gold ratio. To generate a boom-to-bust warning the line on this chart would have to move below its 200-day moving average, but currently it is in a clear-cut upward trend and not far from its cycle high.

Clearly, neither of the indicators that in the past have always warned prior to the start of a boom-to-bust transition for the US economy is close to triggering. This means that the economic boom* that began during the second quarter of 2020 remains in full swing. Furthermore, as things currently stand it looks like the start of a boom-to-bust transition is at least six months away.

For long-side speculations and investments, during the boom phase of the cycle it’s important to emphasise assets and commodities that do well during booms. For example, industrial commodities (e.g., energy, base metals, lithium, rare-earths) generally should be favoured over gold during the boom phase, with the opposite applying during the bust phase. This may seem like a statement of the bleeding obvious, but a lot of market participants stay bullish on certain investments and bearish on others regardless of whether the economy is in the boom phase or the bust phase.

*An economic boom is a period of generally-rapid economic activity fuelled by monetary inflation. It does not necessarily involve sustainable economic progress. In fact, most of the apparent gains achieved during the boom tend to be relinquished during the subsequent bust.