Crude Oil Market Analysis (1/25/07)

Today the market followed yesterday’s forecast that “it has little direction as the bulls and bears sort themselves out.”

The market opened at $55.16 and continued yesterday’s rise to a high of $55.87. But the market had no direction, so it turned around to drop steadily to close at $54.23.

Today’s market decline may have been caused by certain bearish news. First of all, yesterday’s DOE report was clearly bearish—and was perceived to be so after its release, so today’s market decline may have come as a delayed reaction to yesterday’s DOE report. Secondly, the market may again have embraced its skepticism that OPEC will strictly comply with its production cut after Oil Movement expects OPEC export to rise by 270,000 barrels per day for the four-week period ending Feb. 10. Finally, existing home sales in December fell to an annual rate of 6.22 million units, a 0.8% decrease from November's annual rate of 6.27 million units, culminating in the total sales for all of 2006 dropping by 8.4% to 6.48 million units from a record 7.08 million units in 2005, the steepest drop in percentage since the 17.7% drop in 1982. The foundering housing market bodes poorly for the demand for commodities such as energy and metal.

Crude Oil Market Analysis believes that the above three factors may be used as, but not necessarily are, the reasons behind the market decline today. The truth of the matter is that given the market volatility, the market does not need any particular news to move in a $1.77 range.

One major change in the market, however, warrants a special attention by market participants, which is the increasing open interest and the associated volatility. There are a record number of over 1.3 million outstanding crude oil contracts as of Jan. 16, 2007, and this record number reflects a sea change in the market sentiment toward the energy market even among the traditional hedgers. (This is not to be confused with hedge funds, which are speculators.)

Traditionally airlines, among others, are the genuine hedgers that use the futures market to hedge against risks associated with the fluctuation of energy prices. In 2006 after AMR, the parent company of American Airlines, broke even for its energy hedging operation with gains for the first half and offsetting losses for the second half, a senior AMR executive said, “hedging is one of those things you have to be careful with.” Apparently AMR was dissatisfied with the result of breaking even for its hedging operation, but AMR’s attitude toward its operation is ironic because the purpose of AMR’s hedging operation is exactly what was achieved—breaking even despite the market fluctuation of energy prices. AMR was dissatisfied with the hedging operation presumably because it viewed its hedging operation as a profit center, much in the same way Enron’s trading arm was expected to do. But AMR is in the business of transporting passengers by air, not in the business of trading energy futures. As more and more traditional hedgers view energy trading as a means of generating profit, the open interest will continue to increase, and such an increase will inevitably bring higher level of volatility to the market.

Fundamentally the market risk is gradually tipping toward the upside, as the cold weather pattern remains stagnant over much of the U.S. with no sign of going away. As the cold weather continues while refinery turnaround remains low, the ample distillate stock that has justified the current market price will gradually shrink, thus tightening the supply at a time OPEC begins to implement its second round of production cut.

Technically, as COMA forecast yesterday, “after closing above $55.00 for two consecutive days, the market has placed a firm floor on $50.00 in the short term.”

Strategy: Buy at $53.35 with a stop at $51.85; take profit above $57.50.

Dr. Chen

QUOTE OF THE DAY

Since Crude Oil Market Analysis cannot determine the precise reason for today's market decline, perhaps the best way to describe the reason behind today's market decline is to quote former Defense Secretary Donald Rumsfeld when he responded to reporter's question about the alleged link between Saddam Hussein and al-Qaeda on Feb. 12, 2002.

"There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns--the ones we don't know we don't know."

Perhaps the reason behind today's market decline is either a "known unknown" or an "unknown unknown."