My money is on a big commodities rebound – here’s why

The commodity sector is in the doldrums. Surely, everyone now accepts that as a given with all of the negative coverage it has received recently. We’ve become used to seeing almost daily headlines proclaiming record low prices in commodities from iron ore to crude oil, to base metals and UK milk. And these stories are now frequently appearing in the media.

As you know, I generally follow the rule that when a particular story moves from the specialist research departments to appearing regularly in the media, that story is about finished. That is the basis I am working on with commodities.

Also, in the rather more professional forum at the seeking alpha site, the commodity section is attracting only a handful of articles.

When a sector has been in a bear trend for some time, the number of articles invariably dries up. Is that because most people are only interested in bull markets? Do most people fear short selling as a strategy for profit?

Crude oil looks set to bounce back to about $60

In any case, I use such an observation to pose the question all contrarian traders ask: are commodities oversold and due a rebound? And if so, how high will that rebound be?

The pillar of the commodity complex is crude oil, of course. And this market has been getting more than its fair share of negative press in recent weeks. So today I want to examine the case for a possible turn-around in this market.

Here is the daily chart of US crude. From the $112 high exactly two years ago, the market has been in decline. But the steepest decline occurred between June last year to the January low. This has all the hallmarks of a third wave.

US crude price chart

(Chart courtesy www.elliottwave.com)

It came at a time when many pundits were calling for prices to remain above $100, based on the assumption that Saudi Arabia – the traditional swing producer – would cut its production as it had in the past to maintain that floor. That was because US shale production was starting to flow and stockpiles were starting to build.

But a funny thing happened on the way to that $100 floor. Saudi Arabia did not cut production and instead seemed to engage in a price war with the US frackers, with their much higher costs, to drive them out of business.

That realisation slowly pervaded the market and the oil bulls were forced to liquidate positions in the massive wave 3 decline.

Meanwhile, production has been increasing as shown in this chart:

Global oil production chart

With production still rising, how can crude prices stage a rebound? That is the question asked by most investors. But it is the wrong one to ask. Prices are moved by sentiment, not by hard data. The correct question is this: if crude oil rallies, how will this affect production?

In fact, production levels have little bearing on the market. Otherwise, how could production have risen so sharply for decades until 2013 while prices rocketed?

But for a trader, the key observation of the price chart is that the market has now declined to levels below the wave 3 low and is thus in the final wave 5. That means that the entire five down could reverse at any time.

If it does, then what would a ‘normal’ rally look like? Many counter-trend moves do make it to the previous wave 4 extreme at the very least, and often much further. That would place a target at the $60 area and would be my best guess for a first goal.

This chart suggests that copper could rally at any time

Are there any other commodities on the verge of a turn?

Dr Copper – the metal with the PhD – has also been in severe decline with prices making multi-year lows. The latest leg down has been forming a declining wedge pattern (declining because both wedge line are pointing down). But there is a looming momentum divergence, indicating selling pressure is drying up. A break of the upper line would then point to the start of a rally phase:

Copper price spread betting chart

Here is the latest commitments of traders (COT) data showing the specs are net short:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of 25,000 pounds) Open interest: 195,724
Commitments
60,282 94,037 31,180 88,653 48,097 180,116 173,314 15,608 22,410
Changes from 08/04/15 (Change in open interest: 13,943)
-334 1,083 9,671 3,123 1,188 12,460 11,941 1,483 2,002
Percent of open in terest for each category of traders
30.8 48.0 15.9 45.3 24.6 92.0 88.6 8.0 11.4
Number of traders in each category (Total traders: 302)
77 140 77 54 45 178 235

 

Note that in the latest week, the commercials (smart money) increased their net longs as prices fell. Conditions are right for a turn to occur at any time.

So, with the short commodity trade being a very crowded one, my money is on an upturn occurring somewhere around current levels.