Crude’s disconnect – What it means and how to trade it

This past week, energy markets behaved in what many people view as an unusual manner.

As crude oil futures exhibited one of the largest weekly declines in a while, natural gas held steady and even rallied around the middle of the week.

To add even more confusion, those moves happened as the major stock market indices strengthened again to challenge their all-time highs. So, what is going on? Why is crude underperforming so badly relative to natural gas and stocks?

First, let’s look at the crude/natty relationship

As I write on Friday, crude has lost over 5% on the week, dropping from well over $67 on Monday to around $63, while natty went from around $3.05 early Monday to close to $3.15 on Thursday, before giving back some gains on Friday to sit slightly below the early week levels. Considering that traditionally, both commodities are extremely sensitive to economic conditions in the US, why are we seeing this divergence?

Well, while it is true that economic conditions are an important part of the pricing equation for oil and natural gas, they are not the only powerful influence. Supply matters too, and that is what is driving current moves. Overall, the oil market is oversupplied, while the natural gas market is being squeezed by relatively low output.

The irony here is that the expected drop in natural gas supply is mostly as a result of proposed reductions in domestic oil output to address the oversupply there.