From the December 01, 2006 issue of Futures Magazine • Subscribe!

Mapping crude oil prices

This much is obvious: to profitably trade markets, it is necessary to predict the movement of prices. However, price action can be predicted only in terms of probability; nothing is certain. Many traders have been broken by not realizing that even though an event is highly probable, it still may not occur, and that even though an event is highly improbable, it still may occur. This is true in any market, and heading into 2007, it is true for the extremely volatile crude oil market.

Throughout time probable events will become actualities more often than not. This brings us back to the problem of evaluating price movement probability. The two methods commonly employed to do this are technical and fundamental analysis, and the proper application of both is necessary for an analysis of the probable, but by no means certain, direction of crude oil prices in 2007.

BEHIND THE PRICES

Technical analysis holds that prices and price actions depend on market sentiments, which are often stated to be fear and greed. This approach assumes that the most reliable indicators of future prices via market sentiments are price action, volume, open interest and indicators based on these measures.

Another area of technical analysis draws on certain whole Fibonacci values obtained by adding successive numbers such as 1, 2, 3, 5, 8, 13, 21, 34, 55. Other analysis methods that are generally lumped in the technical analysis area assume prices tend to turn near symbolic whole numbers. The $30 level in the past was seen as a sure sign of overbought conditions. As the market rallied, the benchmark rose to $40, $50, $60 and so on until no one could get anyone’s attention unless they called for $100 crude oil.

Implied in these techniques are the tenets that price actions indicate future prices by providing information on underlying/changing market sentiments and that financial history tends to repeat itself. In other words, the way sentiments affect price actions remains basically the same through time because human emotions and actions based on them remain the same.

Certainly, technical analysis is not perfect. It assumes everything affecting sentiment is in the market price. It makes no provision for new, unexpected news that may enter the market suddenly and change sentiment. Of course, news is constantly entering the market, some of which may markedly change sentiment. Any and all technical analysis may fail at any time due to unexpected news.

While few markets are as sensitive to news shocks as crude oil, technical analysis still provides a great deal of information about the current condition, and possible future direction, of crude oil prices.

Crude oil prices have been in a multi-year long-term uptrend. Prices recently closed below the uptrend lower channel line; this is a traditional technical signal that tends to mark the end of any existing, prevailing trend. Confirming this break, the subsequent pull up did not reach the prior high. Prices then fell and have continued to decline into the fourth quarter of 2006.

It is impossible to predict accurately how low prices will fall before bottoming. It is a fool’s game to try to forecast bottoms before they happen. Rather, the technical analyst should look for signs of a bottom as it occurs.

Typical bottoming signs include:

Price pull downs and pull ups do not make new lows.

A bottoming chart pattern is formed, such as a double or triple bottom.

Directional indicators such as On-Balance Volume, the Relative Strength Index and moving average convergence-divergence turn upward.

Trend reversal candlestick patterns are formed, such as dojis and hammers.

The downtrend upper trendline is penetrated decisively.

The 50-day moving average crosses above and rises above the 200-day moving average.

When you begin to see these signs, it is time to consider covering shorts and looking to possibly establish long positions. The longer and more extensive the decline, the more likely an otherwise soundly bullish market has become oversold and, after bottoming, will turn higher and then advance.

MARKET PULL

The other side of forecasting the probable direction of market prices is fundamental analysis. Fundamental analysis holds that price is determined by supply and demand for the commodity that is currently being priced.

This approach implies then, that supply and demand now, and to a limited extent in the future, can be evaluated by past and present numbers relating to production, inventory and consumption.

Like technical analysis, fundamental analysis has its drawbacks. It assumes calculations based on numbers are reliable. Indeed, calculations can be made more than one way, certain assumptions are involved, and the basic numbers may not be correct.

To put full faith in fundamental analysis, you have to assume that the figures do not lie. Even if you accept that this is true, few doubt the related saying that “liars figure.” Simply put, the numerical results on which fundamental analysis is based may not be accurate.

Crude oil market watchers will understand the statement that uncertainties in supply work to support prices. These uncertainties include possible interferences with transports of crude to refining facilities by pipelines and tankers, and problems related to refining and transport of refined products to consumers.

Uncertainties on the demand side include possible changes in consumption quantities related to the weather, currency values, etc. Due to these uncertainties, fundamental analysis must be considered of limited value concerning prediction of future oil prices.

Of course, a big factor in demand is the time of year. In the Northern Hemisphere, the seasonal September through November “shoulder period” of declining demand for energy has just transpired. In this period, natural gas demand for both space heating and air conditioning is minimal, as is heating oil demand. Demand for gasoline has also declined from the peak summer driving season.

The Gulf of Mexico hurricane season runs from about June into November. Because just a hurricane threat to this region is enough to markedly reduce production, the possibility of hurricane-induced price spiking must be kept in mind.

After November, demand picks up for cold winter weather natural gas, and heating oil demand picks up for space heating. Gasoline production is weakly competitive with heating oil, but winter gasoline demand ordinarily tends to decline slightly due to bad winter driving weather. Current geopolitical considerations, such as tensions with Iran and North Korea, possible Nigerian strikes, etc., work to maintain price supports.

Based on the most recent figures available, the amount of crude oil in commercial storage is plentiful. Inventory is supposedly stable. The Organization of Petroleum Exporting Countries (OPEC), the world’s largest oil cartel, has repeatedly stated that crude oil will be supplied as necessary to stabilize prices at levels economically satisfactory to avoid a world recession.

It appears that at this time supply and refining capacity are both adequate. In theory, demand should have declined due to high prices. Then lower crude oil prices should become probable through time. This is what we have seen as prices have dropped the last couple months of 2006.

CRUDE OIL IN ‘07

Based on what we know about technical and fundamental analysis, we can construct a roughly probable crude oil price action scenario for 2007. Of course, energies of all types are one of the most shock-susceptible market sectors, and any positions in these markets should be placed with flexibility in mind.

The negative price indications of the well-defined present downtrend suggest still lower prices due to the absence of bottoming or reversal signs. Fundamentally, the seasonal and geopolitical considerations are bearish. The hurricane season is nearly over and no threat to production has materialized, and while tensions in the Middle East, particularly Iran, remain, there is no imminent threat of a new hot war. One positive sign for bulls is OPEC’s apparent decision to cut production, but with cartel members bickering about where those cuts will come from, production levels may remain the same until prices fall further.

Fundamental data indicate crude oil/distillate stocks, excluding gasoline, have been rising for some time and are higher than last year at this time (see “Supply on the rise,” below).

However, an especially cold and prolonged winter would increase heating-oil demand. Demand for gasoline is believed to have declined, if only slightly, due to seasonal consideration and relatively elevated prices. Just how long it will take to complete 2005 hurricane related supply and refining repairs remains to be seen.

Considering this, in the absence of new bullish news, crude oil prices will probably continue to decline.

Remember, however, how low prices may go cannot be reliably estimated because future supply and demand depend on unpredictable future events, such as the severity of possible late-summer hurricane damage, supply decisions by OPEC, winter weather temperatures in the United States, etc.

This said, the long-term trend for higher crude oil (and distillate, natural gas and coal) prices is decidedly higher. World fossil fuel supply is limited and demand is increasing. Lower prices increase demand and moderate supply. This works to moderate price declines and promote higher prices.

While conditions are ripe for a dip in crude oil prices in 2007, they will not likely drop below $45 per barrel. This represents a roughly 33% drop from the 2006 high. And, a drop to $45 is near the Fibonacci number of $34, as well as just below the powerful symbolic number of $50.

It is possible that prices might drop and stay lower for a while longer than commonly anticipated. However, before the advent of the late summer hurricane season in 2007, probable production cuts by OPEC, plus increased demand, will probably have initiated a new uptrend. How high prices will then carry remains to be seen.

Keep in mind that this analysis, and all forms of analysis that rely on past and current data to forecast the future, assumes there will be no new major events markedly affecting supply and demand. Such events could be changes in hurricane season frequency or intensity, unexpected changes in OPEC oil policy, unexpected economic recessions, armed conflicts, or any number of other occurrences that could affect oil prices.

Both technical and fundamental analysis are inexact sciences, but when correctly applied they suggest the probable future direction of market prices. Traders just need to remember that “probable” does not mean “always” and that the worst-case scenario is always possible.

Phil Duke is a U.S.-based independent trader, consultant and analyst. E-mail him at

drpduke@wmconnect.com.

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