Fundamental Analysis
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November Crude Oil futures finished another “observation” week with a slight down tick from the previous week. It was another observation week because all traders did was watch and observe the fourth consecutive week of sideways price action.
Traders showed little reaction to another weak economic report out of China, hawkish talk from several Fed officials, or a potentially bearish inventories number from the EIA. There was also little movement during September with the November futures contract posting an inside move. Although this chart pattern indicates trader indecision, it also signals impending volatility. We’re just going to have to figure out the catalyst that will make this market run.
From observing four-weeks of sideways action, we can see the trigger points for potential breakouts in either direction. However, breakouts can fail if they don’t have volume behind them. In other words, for a successful upside breakout, we are going to have to see better-than-average size on the bid. This will indicate the presence of real buyers. Given the bearish fundamentals, a rally will not be sustainable if the move is generated by buy stops.
On the downside, we are going to have to see fresh shorting pressure on better-than-average volume. Sellers are going to have to be willing to sell weakness because sell stops alone will not be able to sustain a breakout to the downside.
In…
Fundamental Analysis
(Click Image To Enlarge)
November Crude Oil futures finished another “observation” week with a slight down tick from the previous week. It was another observation week because all traders did was watch and observe the fourth consecutive week of sideways price action.
Traders showed little reaction to another weak economic report out of China, hawkish talk from several Fed officials, or a potentially bearish inventories number from the EIA. There was also little movement during September with the November futures contract posting an inside move. Although this chart pattern indicates trader indecision, it also signals impending volatility. We’re just going to have to figure out the catalyst that will make this market run.
From observing four-weeks of sideways action, we can see the trigger points for potential breakouts in either direction. However, breakouts can fail if they don’t have volume behind them. In other words, for a successful upside breakout, we are going to have to see better-than-average size on the bid. This will indicate the presence of real buyers. Given the bearish fundamentals, a rally will not be sustainable if the move is generated by buy stops.
On the downside, we are going to have to see fresh shorting pressure on better-than-average volume. Sellers are going to have to be willing to sell weakness because sell stops alone will not be able to sustain a breakout to the downside.
In early September, crude oil futures volatility spiked to 96.25%. But volatility does not behave like prices. It doesn’t keep making higher-highs as it moves up, or lower-lows. After spiking to the upside, it tends to regress to its mean. The price action the past four weeks indicates this process is taking place. So just like relatively high volatility will lead to relatively low volatility over time, the process works the same way from the bottom up. To put it another way, we are waiting for volatility to bottom out. Currently, it is nearly 50%.
The supply/demand fundamentals haven’t changed much over the last four weeks, but the money flowing in and out of the crude oil market seems to have changed. If you can remember back to late August, the financial markets were in turmoil after China reported weaker-than-expected manufacturing data. This report indicted a contraction in the sector, sending the Chinese and global stock markets sharply lower. Additionally, China had just devalued its currency. Investors were also talking about a possible rate hike by the Fed in September.
Crude oil plunged with the rest of the markets, however, after reaching a nearby contract low just under $40.00, it embarked on a 30% rally. The headlines said that short-sellers aggressively covered their positions after OPEC officials said they were willing to listen to producer complaints about low prices, but that story has come and gone, and the market is still trading near its highs from a month ago and well off its low for the year.
In hindsight, the rally may not have been related to an oil market event at all. Because open interest dropped on the move, we know it was fueled by short-covering (Futures 101: Price Up, Open Interest Down – Shorts Getting Out). Total oil stockpiles are still high. U.S and OPEC production remain robust and the rig count has not been reduced enough to make a difference. Given all of this information, I have to conclude that the rally was likely related to margin calls in the outside markets.
The huge drop in the equity markets, coupled with a plunge in the U.S. Dollar, a rapid rise in gold and spike in Treasuries may have triggered a number of margin calls in the futures markets that needed to be covered. Fund managers, sitting on huge profitable positions in crude oil, probably had no choice but to reel in their profits in order to meet their financial obligations in their other futures positions.
Since that volatile move in late August, many financial markets have settled into a range just like crude oil. The relative calmness is part of the process of investors getting used to fresh news and perhaps a shift in sentiment. Once they adjust to the new risk factors, they will return to watching and reacting to the traditional fundamentals and traders will pick up where they left off.
Technically, the main trend is down according to the weekly swing chart. The short-term range is $38.51 to $50.04. Its retracement zone is $44.28 to $42.91. Since the week-ending September 4, crude oil has found support at the 50% level at $44.28.
The 50% level is a possible trigger point for a break into the 61.8% level at $42.91. The level is the trigger point for a possible acceleration to the downside. If crude oil doesn’t rally to near $50.00 then traders will be forced to sell weakness through the 61.8% level. The market will move quickly through this level if the major funds come back into the market with better-than-average volume.
Holding $44.28 may be indicating the presence of buyers, but it is probably the lack of sellers preventing this market from moving lower. If there is a rally, it will likely be short-covering due to an outside event like an escalation of the fighting in Syria. A rally will likely be capped by the $50.04 to $51.77 area unless weak shorts get scared out of the market on the news. There should not be a prolonged rally because of Syria unless there is an actual disruption in the supply.
In summary, be patient. If you are a conventional trader, then wait for the volatility to drop to normal levels. The fundamentals haven’t changed much over the last 5 weeks so there is still a bias to the downside.
If you are a speculator, then you will have to be willing to trade both sides of $44.28. As long as this area holds as support then you can lean on the long side. You may catch a break with a short-covering rally if the war in Syria leads to a disruption in supply.
If volatility falls to a reasonable level and the market is at support then watch for a volatile move to the upside. If the market is below support at $44.28 then crude oil is likely to expand to the downside. The price levels are only one factor in the equation. Watch and observe the order flow and the volatility at each support and resistance level. It will tell you whether the bulls or the bears have the upper hand.
