Crude Reality

Fundamentals

Crude Oil futures are little changed this (Wednesday) morning, after dropping sharply with the equity markets yesterday. The G7 meeting this past weekend was dominated by pessimism and confusion. The leaders of industrialized nations were unable to come close to any sort of agreement on how to deal with the deepening global economic crisis. Japan stated that its economy shrank at the fastest pace in over 33 years in the fourth quarter, dampening the prospects of a demand revival for the third-largest petroleum user.

Energy traders are now suggesting that the IEA’s forecast showing world Crude Oil consumption falling by 1.2 million barrels a day may be a conservative estimate. Even if the estimate were aggressive, the production cuts by OPEC only amount to roughly half of the decline in demand. The cartel must now weigh their options. If further cuts to production are made, prices could stabilize more quickly, but price increases could stymie efforts to get global economies back on track. This short-sighted strategy could easily backfire on the cartel. On the other hand, prices risk falling into the abyss if nothing is done.

On the geopolitical front, the strong rhetoric between Israel and Iran has cooled in the past week, due to election turmoil in Israel. Nigerian rebel group MEND has threatened Italian Oil operations in the country, and could forcibly cut the flow of high quality Crude Oil from the African nation. The group has made good on threats in the past, and there is no reason to believe it will not do the same this time around if it chooses.

Price action on Friday was rather unusual, with the front-month March contract posting rather sharp gains, while back month prices fell. This suggests traders may have unwound their long back-month short near-month spreads to take advantage of the contango, which had reached $16 (1 to 5 month) at one point last week. The weakness of the back-months relative to the March contract continued to a much lesser degree yesterday.

The Crude Oil ETF United States Oil Fund (USO) rolled a good portion of their positions forward last week, which explains why traders pushed the monthly spreads so wide. It is never a good idea to telegraph what your intentions are to the market, especially when you are rolling a sizable position, as the fund managers learned last week. The contango remains at irrational levels, giving traders with financing and storage the ability to earn handsome, risk-free profits by taking delivery and selling deferred contracts to re-tender at a later date.

Logic would suggest that this spread should narrow, especially given the grim economic outlook, but logical trades can backfire severely if not timed correctly (think tech or Crude Oil bubbles). Illogical situations can last months or years, making spread trading just as treacherous as trading the outright futures contract.

Technicals

The April Crude Oil contract took-out the December 24th low at 39.82, which can be seen as a downside breakout. The March contract had previously taken-out this level, but deferred-months remained strong relative to the front-month contract. It would not be surprising to see the market come back to test this freshly established resistance level in order to verify the downside breakout. Momentum has remained strong, despite the sharp dip yesterday, and is now diverging from both price and RSI. This hints at possible near-term strength.

- Rob Kurzatkowski, Senior Commodity Analyst

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