Sunday, December 17, 2006

Crude oil prices remain in a trading range as of 12/17/2006

Although crude oil futures moved up moderately this past week due to talk of OPEC cutting production quotas, they remain within a fairly narrow trading range, hovering within a couple of bucks on either side of $60 and within the $55 to $65 range, continuing to reflect market uncertainty as to whether the next major move is to the upside or the downside. This trading range scenario is not inconsistent with the possibility that crude oil may rally moderately at some point in the not too distant future, even as there is also the possibility of a further withdrawal of speculative capital from the commodities markets causing a significant decline in prices.

As far as OPEC and production quotas, although I expect there will be some cut in production since there really is a glut in crude oil inventories, OPEC members are notorious for cheating on their self-imposed quotas. The news of quota cuts causes traders and speculators to bid up prices in the near term, but as the days and weeks tick by, those speculative positions will evaporate as the returns become more anemic or turn into outright losses. Also, some of these so-called production cuts will simply be the result of anticipated shutdowns for maintenance and development.

At Friday's closing price of $63.43 (vs. $62.03 a week ago), January crude oil futures are poised to either begin backtracking downwards in the trading range or to in fact stage a breakout. The former seems more likely, but the timing is of course unclear. Crude could move up a bit more before reversing. I would note that crude inventory levels are still quite high despite OPEC cutting their production quotas, so there is little fundamental reason for crude to move much higher.

Crude oil futures prices are in contango (rising as you go out in delivery date) through September 2008, so we could see crude tick up each month for quite some time as each front month expires and the next month becomes the front month. For example, if there were absolutely no change in prices, crude would jump from $63.43 to $64.09 on December 20, 2006 as trading of the January contract ceases on December 19 and the February 2007 contract becomes the front month for trading. That's a $0.66 jump. Similarly, there is a $0.80 jump from February to March futures ($64.89). And so on up to a peak of $69.06 in September 2008. Then, futures go into backwardation (declining prices) all the way out to December 2012 ($66.69). All of this is subject to dramatic change, even on a daily basis.

In short, I am prepared for the possibility of a modest to moderate rise in oil prices in the coming months, even as I feel that a decline is likely at some stage, especially if economic growth continues to be modest and the commodities markets continue to hemmorage capital as frantic speculators grow increasingly weary of anemic or even negative returns.

I would also note that since gasoline prices remain at a fairly high level, the vast majority of car and truck buyers will be very keen to raise their personal energy efficiency. This will be a slow evolution, but the per-capita consumption of energy (at least in the developed countries) is likely to trend down for the forseeable future.

I would also note that the mentality of short-term commodities traders is compatible with the people who are loudly proclaiming that the economy is falling off a cliff due to the so-called "housing recession" and that a full-blown recession is coming in 2007. I don't concur with that outlook, but nonetheless many people do and that could lead to additional downwards pressure on commodities futures. Not seeing such a retreat in commodities lately, I can only conclude that the economy is in fact significantly stronger than the pundits suggest.

Overall, I expect crude oil prices to remain in a relatively narrow trading range of $55 to $65 for the next few months, until we finally see a wholesale exit of the commodities speculators or some renewed economic strength.

-- Jack Krupansky

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