Crude Oil Market Analysis (1/26/07)

PRELUDE: IN DEFENSE OF THE BULLS

As soon as the market dropped by 36% from July’s high of $78.40 to last week’s of $49.90, some analysts began to feel vindicated and claim credit for their forecasts by saying, “I told you so when the market was at $78.”

Yes, sir! You said so last summer, but you did not say, “no hurricane will affect Gulf production this summer,” or “the winter will have record-setting warmth.” Now you claim the credit for what is due to Mother Nature. The matter of fact is that not a single hurricane affected the Gulf oil production last summer, and the U.S. Midwest and Northeast had a record-setting warmth in December. If four hurricanes had shut down Gulf oil production in the summer followed by record-setting cold temperature, today’s oil price would be close of $100, not the “high” price of $78.

The bulls who got long last summer at $78 in anticipation of these events were justified to do so. Only in hindsight do the bulls look silly. But hindsight is always 20-20.

BusinessWeek’s Feb. 5 issue calls for a supply-demand equilibrium at the current price and writes, “it’s anyone’s guess where oil prices will go from here” (p. 39). BusinessWeek cannot be wrong in its statement because that “it’s anyone’s guess where oil prices will go from here” is a perpetual truism that cannot be defeated.

Journalists write this type of “true” statement because they have to write something, as much as sports commentators make certain “true” observation because they have to make comments.

At last Sunday’s NFC Championship game between the Saints and the Bears, the Saints challenged a ruling of a fumble on the field rather than an incomplete pass. After the referee upheld the ruling on the field, a Fox Sports commentator, either Troy Aikman or Joe Buck said, “there is no conclusive evidence to overturn a call either way, so a ruling of an incomplete pass probably would also stand.” Of course, a ruling of an incomplete pass would stand as it always does because it cannot be reviewed.

Today’s market action followed yesterday’s forecast, as Crude Oil Market Analysis stated yesterday that “the market does not need any particular news to move in a $1.77 range, and that “Crude Oil Market Analysis cannot determine the precise reason for today's market decline.” Instead, COMA gave a reason for the market to rise today by stating that “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.”

After yesterday’s $1.15 decline to close at $54.23, the market rose steadily from the overnight low of $54.20 to close $1.19 higher at $55.42, leaving the market almost unchanged after two days.

In addition to the persistent cold weather pattern, another bullish news today is the report by Lloyds that OPEC export fell to below 23 million barrels per day from November’s below 24 million barrels per day after having fallen 700,000 barrels per day from October. The Lloyds report is not necessarily contrary to the report yesterday by Oil Movement that OPEC export will rise by 270,000 barrels per day for the four-week period ending Feb. 10, which report may have caused the market to fall yesterday.

Although the underlying weather condition and the impending OPEC production cut on Feb. 1 both contribute to a bullish sentiment in the market, Crude Oil Market Analysis perceives a bull trap, or more precisely, a CONSPIRACY in the current market turnaround.

First of all, Nymex daily crude oil volume has been steadily falling since hitting an all-time record of 800,371 contracts on Jan. 11. Jan. 24 volume was 412,024 contracts followed by Jan. 25 volume of 367,449 contracts, two consecutive lows so far this year. The consecutive lower volumes occurred in a rising market from a low of $49.90 to above $55.00.

But an even more sinister omen is today’s CFTC’s COT report. The report shows that for the week ending on Jan. 23, 2007, a day the market had the most increase of $2.46 since Sept. 15, 2006, the net short interest increased from 2,032 contracts to 8,499 contracts amidst a steep decrease of 47,782 contracts in open interest. In other words, in a week when the market had a $3.08 increase in a sign of bottoming out, the longs were bailing out; in contrast to the previous week when the market had a $4.43 drop, the longs were rushing in.

It is not unusual that when the market begins to bottom out, the longs exit the market because those longs who were trapped in lower prices at the market bottom now sigh a relief and exit the market to cut their losses. Such a long exit usually is preceded by short-covering as the shorts see the market bottom and protect their profits.

However, the circumstances surrounding the market turnaround this time is very suspicious.

As Crude Oil Market Analysis observed on Jan. 19, “the CFTC’s COT report shows that for the week ending on Jan. 9, the non-commercial interests had gone from a net long of 2,194 contracts to a net short of 22,358 contracts, a whopping change of 24,552 contracts amidst an increase of 53,651 new open contracts. But in the following week ending on Jan. 16 the net short interests fell by 20,326 contracts to merely 2,032 contracts amidst another huge increase in open interest by 37,088 contracts.”

When COMA made the observation on Jan. 19, COMA could not explain such an unusual market action as to why the longs would pick a market bottom in a bear market before the shorts saw the market bottom, effectively attempting to force the shorts’ hands to cover “or else.”

After three weeks’ CFTC’s COT reports, a clue appears that it is not the longs who forced the shorts’ hands, but vice versa.

There has been a rumor--that is, a rumor, a gossip, a hearsay, a speculation, a guess--on Wall Street that a collapse of the Amaranth magnitude is brewing and will materialize if the market falls below $50. Such a rumor appears to be the missing link among the last three CFTC’s COT reports. The following explanation would piece together all parts of the puzzle and make sense.

The bear market was in full throttle as the bears rode the bandwagon from $61.05 all the way to $55.64, as evidenced by the influx of shorts for the week ending on Jan. 9. As the market continued to fall, certain market participants realized that they would face a margin call if the value of their contracts should decrease when crude oil drops below $50.00, and these market participants were forced to support the market by continuing to accumulate more long positions even though the shorts saw no need to cover their positions. As a result, the longs increased their strength even in a week ending on Jan. 16 when the market continued to fall from $55.64 to $51.21.

On Jan. 19 COMA could not explain this “catching-a-falling-knife” phenomenon other than to say that “as the longs are convinced that the market is going to turn at this moment, the shorts are sitting tight waiting for the next leg of downward movement.” The explanation now in retrospect is that the longs would rather take a chance to catch a falling knife than be a sitting duck and be slaughtered by the shorts, and such an epic battle between the longs and the shorts resulted in the record trading volume of 800,371 contracts on Jan. 11.

As the market held above $50.00, some shorts began to cover to take profit, which gave the market a boost. As the market rose, the longs exited mostly before $55.00 for fear of another bear assault. Once the longs exited the market on or before Jan. 23 when the market closed at $55.04, the epic battle that occurred for over a week ended, and the trading volume in the market fell precipitously to two consecutive year-to-date lows on Jan. 24 and Jan. 25 for 412,024 contracts and 367,449 contracts, respectively.

This is a big conspiracy theory, though. However, Crude Oil Market Analysis has no other ways of tying together all these facts which COMA can observe since the New Year and which do not conform to the common sense of trading. The credibility of the conspiracy theory will be proved or disproved by market action and data in the next few weeks.

Although alleging that Secretary Bodman is part of the conspiracy would be tenuous, the eerie timing of his announcement on Jan, 23 is worth noting.

Crude Oil Market Analysis stated on Jan. 19 that “if the market cannot stay above $54.00, it will again test and break the $50.00 support.” Then COMA stated on Jan. 22 that “the bulls need the market to stay above $53.10 just to avoid another bear assault to run toward the contract’s low of $51.03. However, unless Wed.’s DOE report shows a crude oil draw of 2.5 million barrels or greater, the market’s test of the $50.00 support is inevitable. In other words, it is not that the fundamentals justify the market’s drop to $50.00, but it is that the market wants to go there.” COMA was fairly certain about the market’s will to retest the $50 support.

After a failed attempt by the market to trade above $54.85 to close at $52.58 on Jan. 22, on Jan. 23 the market rose steadily from the overnight low of $52.41 to $53.94 at 12:30 p.m. but could not break $54.00 and then fell to $53.23 at 1:30 p.m. In other words, the bears had done $0.70 out of the $0.93 job needed to push the market down to $53.00. Once the market touched $53.00, it would not look back and would go straight to test the contract low of $51.03 and then the $50.00 support for the March contract. And the bears had almost one hour to chip away the last 23 cents before the pit trading would close.

At this critical moment Secretary Bodman announced the U.S. plan to double its SPR to 1.5 billion in the next 20 years. Then the rest is history. The bears were as close as 23 cents away from burying the bulls. If the market had dropped below $50, the momentum would carry it to $46.20, and none of the weather conditions would have mattered because once the market decides to move in certain direction, it is blind to underlying conditions, much like a train coasting down a hill without a brake would crush any obstacles on its way.

Fundamentally, the market risk remains on the upside, as the cold weather pattern remains stagnant over much of the U.S. with no sign of going away, thus giving the market a support for the time being.

Technically, the market looks very weak, as the market data show that the rebound in the past week was caused by longs who threw in all their weight to put a brake on a downwardly moving market in an attempt to avoid margin call and forced liquidation.

Strategy: Buy at $53.35 with a stop at $51.85; take profit above $57.50. Sell at $57.25 with a stop at $58.20; take profit below $50.00.

Dr. Chen