Crude Oil's Rise is Only Temporary

Andy Waldock |

The price of crude oil has risen by more than 13% in the last two weeks. The price has been driven up by a perfect storm of temporary factors including seasonal, environmental and political issues. We believe these will subside and return us to a fundamentally over supplied market causing it to fall back below the magic $100 per barrel ma

Crude oil futures traded under $93 per barrel as recently as June 24. This is also the day that flooding concerns began creeping into the news from Alberta, Canada, the largest exporter to the U.S. The flooding eventually shut down pipelines from Enbridge and Penwest Exploration beginning on June 25. Uncertainty regarding future supplies created support for the market. Prices stabilized between $94 and $96 per barrel.

Meanwhile, unrest in Egypt began to grow. It started with the mob beating death of four Egyptian Shiites outside of Cairo. Civil protests calling for the ouster of elected President Mohamed Morsi fell on deaf ears while his primary support came from the fundamentalist Muslim Brotherhood. Egyptian citizens had finally lost their patience with Morsi as basic problems of infrastructure improvement and unemployment began to take a back seat to what was becoming a country ruled by Islamic law rather than the secular democracy that was fought for during last year’s Arab Spring.

The natural disasters and political unrest also came as the market was heading into the first of crude oil’s twin peaks of seasonality. The first peak is Independence Day. The second comes around Labor Day. The combination of all of these factors has forced the crude oil market rapidly higher in the face of weak fundamental data.

Crude oil inventories are well above their five-year average. This spring actually saw the highest inventories in the last five years, nearly touching 400 million barrels in May. This is more than 14% above the five-year average and 3.5% above last year’s inventory. The market remains oversupplied with inventories currently around 382 million barrels, still well above the current five-year average of 337 million barrels. In fact, inventories would be even higher had we not drawn down 10 million barrels last week to meet the temporary decline in Canadian imports.

Crude oil futures are currently trading near $105 per barrel. The technical pattern that has been forming on the daily charts is called an, “inverted head and shoulders.” While many people have seen tops referred to as a head and shoulders pattern, fewer are familiar with its bullish relative. Technically, the pattern is measured the same way. However, instead of subtracting from the neckline to find a target down below, we simply add the distance from the right shoulder to the neckline to generate an estimated high price for the move. In this case, the estimated target is around $106.50 in the September crude oil futures contract.

The situation in Egypt is the only wild card still in play. Mohamed Morsi has been ousted as President. The Egyptian military now appears to be running the country. Calls are already being made to host a new Presidential election along with proper monitoring of the voting process. The United States has remained curiously aloof through the recent unrest. President Obama appears unsure of which horse to back and is leaving our options open. Technically, not categorizing the uprising as a “military coup” allows us to potentially back the next ruling party, regardless of the outcome. This is far more palatable than stoking the unrest of a civilian uprising within the Middle East.

Trading the crude oil futures market during a period of Middle Eastern unrest is not for the faint of heart. While we expect the market to top out shortly, there is no telling exactly when the next news announcement may cause the top to be completed. This means we don’t know exactly what the risk may be to our account values. Therefore, a more conservative approach would be to use an option spread that allows us quantify our risk while accepting that our rewards will be limited. The first rule of trading is, “always know the risk.” We will continue to look for reversal chart patterns that would suggest the market is heading back towards its 90-day average price of $95 per barrel.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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