Saturday, January 13, 2007

Is crude oil headed below $50?

Although crude oil has clearly fallen below its recent trading range of $55 to $65, and even below my threshold of $54, the trend is now even murkier. Although I do expect further selling by "investment" speculators over the coming year, it may be too soon to see that selling accelerate in the near term. Sometimes there is a lot of artificial selling that snowballs whenever some "technical" price "support" level such as $55 is breached, but that kind of selling never tells you about the real trend. In short, I do expect more selling by "investors" who are having ever-more difficulty holding speculative positions in such a volatile market, but predicting the precise timing of such selling is a fool's errand.

My primary suspicion for the coming months is that we will simply see a resetting of the range, shifting it down from the old range of $55 to $65 to a range of $45 to $60. The Bush administration seems quite committed to rattling sabers with Iran and OPEC will continue to nervously talk about maybe needing to cut production quotas, so traders and short-term speculators will have no difficulty getting the price of oil to swing $5 to $8 in either direction. Selling by "investment" speculators (speculators who had been counting on oil to rise over the long-term but hoping it would rise in the short-term as well) will put gradual downwards pressure on that range over the coming year.

Something truly dramatic happened to the price structure of longer-term crude oil futures this past week. For more than a year, prices were split, with prices in contango (rising as you go out in delivery date) through 2008, but then in backwardation (declining as you go out in delivery date) through 2012. But now, in just this past week alone, futures have reverted to a simple contango (gradual rising), from $52.99 for February to $60.94 for December 2012. This is more of a normal trading market. We will have to watch how this evolves further in the coming weeks, but it strongly suggests that some major players have skipped town. That bodes well for the theory that the speculative bubble truly has burst.

Crude oil futures prices are in contango (rising as you go out in delivery date) through December 2012, 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 $52.99 to $53.87 on January 23 as trading of the February contract ceases on January 22 and the March 2007 contract becomes the front month for trading. That's an $0.88 jump. Similarly, there is a $0.79 jump from March to April futures ($54.66). And so on up to a peak of $60.94 in December 2012. All of this is subject to dramatic change, even on a daily basis.

The other good news about this price structure is that it barely reflects inflation over the next five years, making speculation in oil futures that much less attractive compared to even ultra-safe Treasuries or TIPS.

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 dramatic 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.

Overall, I expect crude oil prices to remain in a relatively narrow trading range of $45 to $60 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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