Short Term Direction Of Oil Prices

Yesterday I had a very interesting conversation with a good friend.  He had been following the markets very closely and wanted to know what I thought about oil.  With prices now actively trading above $100 per barrel, several market watchers including my friend thought prices were poised to fall in the short term.

He cited three main drivers indicating oil is overbought:  First the market is getting toppy.  Second, seasonal weakness from the second quarter would reduce demand.  And third, the recent OPEC meeting in Austria would move prices lower.

Now to me, a short term fall in the oil markets would equate to a 10% or 12% correction.  This means oil would need to fall to the high $80s or low $90s.  Could this happen?  Before I tell you my thoughts, here’s what he said.

Oil is toppy.

Toppy is a term used frequently to indicate a near term high in a market. Traditionally it refers to a breakdown of an up-trend.  This can be found in a head and shoulders pattern or the appearance of a resistance line.

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Technical analysts love this stuff.  Clearly oil is showing some very short term signs of hitting resistance at the $102.5 level (note the blue line at the top of the chart).  Hitting resistance like this could mean oil is poised to go lower short term.



Economic Slowdown

The second argument was the seasonal slowing expected in the US economy during the second quarter.  It’s widely known that the second quarter is always slow.  The excitement of year end and Christmas is behind us.  New activity scheduled to start in the spring and summer hasn’t hit full stride yet.  With the economy slow, demand for fuel and other oil related products will fall.  Lower demand means lower prices.

The Wild Card – OPEC

The biggest wild card in the argument is OPEC.  For those of you who don’t know, OPEC stands for Organization of Petroleum Exporting Countries.  The 13 countries that make up the group represent more than 40% of global oil production.  Obviously, what they decide about production has a huge influence on the markets.

Right now OPEC is meeting in Vienna.  President Bush has publicly called for an increase in production levels.  If they decide to increase production (unlikely), prices would most certainly fall.

So, here’s the million dollar question. Should we short oil with the expectation of a near term fall in prices?

I have an easy answer “NO, Nada, nope, not on your life, no-way, NO”. I hope I didn’t confuse you with my response.

Here’s why I say no.

First is the market really toppy?  I have no idea what the official definition is – actually I don’t think there is one.  A “toppy” market is a bit like the famous US Supreme Court comment on obscenity “I know it when I see it.”  Might the market be toppy?  Sure.  Might it be consolidating?  Maybe.  Might we still move higher?  Why not.  I like technical analysis as a confirmation of fundamental influences.  Any market technician will tell you fundamentals trump technicals every day . . . and twice on Sunday.

So let’s look at the fundamentals.

Argument number two is about the slowing economy in the second quarter.  Lower demand means lower prices.  Here is why this is wrong. Oil is a commodity.  Its price is a function of supply and demand.  But new demand is on the market . . . what do you think pushed prices up from $40 a barrel to over $100?  India, China, Russia, and a basket full of other emerging markets.  These countries are growing rapidly and they need oil.  The fall off of US demand for oil will be quickly replaced by demand from these growing countries.

But wait, there’s more . . .

The slowing US economy has another major impact.  The US Dollar will continue to fall.  As the economy weakens, money will flow from the US into other countries and currencies.  This will push the dollar even lower and it has a perverse impact on oil.  A weak dollar actually makes oil cheaper for everyone else in the world.

I know it is strange but think of it this way.  All of the oil traded in the world is denominated in US Dollars.  The Euro has appreciated against the US Dollar by more than 15% in the last year or so.  This means that while you and I spend $100 on a barrel of oil, people in Europe only spend $85 per barrel.  Because oil is “cheaper” for them, they can afford to bid up the price of oil.

Finally, OPEC.  News just came out (literally a few moments ago) that they have decided to leave oil production levels unchanged.
 
“The 13-nation Organization of Petroleum Exporting Countries said it opted to maintain current production levels because crude supplies are plentiful and demand is expected to weaken in the second quarter.”

The interesting thing about OPEC is they have no teeth.  Any member of OPEC can accept or reject the group decision on production.  Something tells me these oil producers rather like oil at over $100 a barrel.  Why wouldn’t they?  Look at all the money they are making.

So there you have it.  I don’t think oil prices are going to correct any time soon.  Actually I think we could see oil at $120 a barrel in the next few months.  If you are holding onto any of the oil producers, like Exxon Mobile (XOM), don’t let go, the ride should continue for some time.

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