Oil Futures Settle in After Monday’s Over-Reaction

Oil

Crude oil futures are already known to be pretty volatile, but events over the weekend really set things spinning. Monday brought a huge spike, but we calmed down more Tuesday.

Saudi Arabia is already scrambling to recover from the drone attacks on Saturday that caused serious damage to a large oil processing facility and an oil well, large enough to in itself cause world production to drop by 5%.

By the time the futures markets opened on Sunday night at 6PM ET, this news caused a huge gap up in oil futures, with Brent going from about $60 at the close on Friday to over $72 a barrel in the blink of an eye. The move with WTI was more muted initially, going from around $55 a barrel to around $61 at the open.

Brent’s price actually peaked at the open, and within 30 minutes it had retreated back to around $67 a barrel, where WTI dropped down to around $59 in the first 7 hours of trading and then put in a secondary rally which saw it reach a peak of almost $63 a barrel before it started to pull back again.

Unless you trade futures, timelines like this don’t matter and you can just check the periodic prices that the media reports, but for futures traders, this move was either more exciting than you could imagine if you were long over the weekend or a nightmare if you were short.

Futures are highly leveraged so when you see double digit moves like this in a period of hours, it is not even that people realized double digit wins or losses during this time, as this takes us way beyond this.

When we realize that people are multiplying their deposits by a factor of 10 on average with these trades, we are talking triple digit movements. Oil futures do move this much at times or more in some cases, but what made this latest move so spectacular was the sheer speed that it occurred at.

You can’t defend against market gaps other than just avoiding them, so those who were short oil with a typical amount of leverage didn’t just lose all of their money here, they lost several times more than that, and there really wouldn’t be any way to prepare or manage something like this because by the time the first trade hit the tape the deal was done.

If you were long some oil futures contracts over the weekend and you heard this news, you weren’t exactly going to put them up for offer at Friday’s prices, and market makers saw this unfold just like we all of us did that heard or read about these attacks.

How the Move Really Played Out

So, when these events happen on the weekend, you get hit with the full impact of the initial response, as opposed to what we see when big news hits during market hours which can see both big spikes and further momentum in the same direction as the market better digests the news.

Over the weekend though, you get it with a day or two of digestion already built in to the price, and while more does go on, both in reaction to further news about the crisis and further news about the market’s reaction to it, this can provide some nice trading opportunities.

Just because you missed the big move does not mean that the fun is over, and a lot of money was won and lost on oil on Monday and Tuesday as well. With these things, the bigger the boom, the bigger the overreaction, and this one had a very loud boom. It would have been pretty reasonable to expect a big overreaction as well this time, and we’ve seen plenty of this happen already.

The media is reporting that oil prices shot up Monday and shot back down a fair bit on Tuesday, and while that was true, those who are looking to take advantage of these things aren’t going to be trading daily charts of course, and a lot happens within a daily bar.

Almost all of the retracement we’ve seen actually happened not Tuesday but Sunday night with Brent and in the early hours of Monday with WTI, so the sharks were already in the water by the time people in the U.S. got out of bed on Monday. The reason why this doesn’t make it in the news very much is that reporters just look at the daily prices that they are given and write their stories around those numbers.

This lack of attention can end up shaping the story that is told, where if we actually look at the trading, Brent didn’t spike at all past the initial trade on Sunday and dropped a lot quickly. Since then, we’ve bounced around a lot and this has been a range-bound market that we haven’t broken out much of on either side.

There have been plenty of good trades during this time, where we have seen moves on both the up and down side, moves of a dollar or two in an hour or two. This sort of event puts hedgers in panic mode, and this really presents opportunities for traders to take advantage of their trading frantically based upon factors other than the charts.

If you actually trade in crude oil, you are going to be trading oil futures with a strong view toward your business needs, as this is why producers and consumers of commodities trade futures. The advantage that traders have over them is that they are in it for the actual oil and traders are only in it to take advantage of the price swings in oil.

It is not that these primary participants don’t trade the charts somewhat, but traders only trade the charts and this does give them a significant advantage. This oil crisis is an excellent example of all of this in action, where we can really see how much of an effect fear on the side of the hedgers can have.

Production Will Be Reduced, But Not by a Big Amount

Oil prices are intimately linked to production numbers, as the demand for it doesn’t really change that quickly and the shocks in this market all come from the supply side. OPEC has known what it was doing all these years by controlling price by limiting supply, as the demand side will compete at a higher price.

When we see production decline, whether it be from drone attacks or for any other reason, this should serve to put the price up proportionately, even though it’s not a direct relationship by any means and there is the means to at least offset the loss through utilizing reserves, as the United States is doing, as well as countries increasing their production to take advantage of this.

The higher the price of oil, the more we can produce economically, and this will also serve to fill the gap somewhat. As the lost oil comes back online, increasing supply further, we will work our way back to equilibrium as the lost supply is recovered and additional production from other sources also return to normal as the opportunity wanes, all things being equal.

We therefore need to reduce the number 5 by something if we’re looking to be accurate in our assessment, because 5 represents a full reduction of that amount in the market. 4% sounds better, although the difference here isn’t that meaningful.

When we learn that that the world’s supply just dropped by 4%, we should expect a similar reaction in the price of crude, raising it by 4%. What we saw instead is a 20% increase in crude oil futures, at least initially anyway, although the initial reaction is important to the story. We could say that 4% of this 20% was what happened and the other 16% was the current price of fear.

It is not traders that are pricing in this fear, and traders get off at the first stop when they get worried very much. The goal of trading is to get out once you get any meaningful amount of fear, so we’re talking about the actions of the participants that are wedded to the commodity, and these folks are known for this sort of reaction.

Futures markets are known to overreact to the more significant events, and especially the very big ones, so this sort of thing is expected. Since we’re dealing with an over-reaction, traders that are looking to play daily trends will naturally look to selling oil contracts to capitalize on this overbought condition.

Saudi Arabia has already made progress on restoring their production and expect to be fully back up in November. If they add back what they lost, this in itself does not provide a reason for the price of oil to be any higher than it was prior to these attacks.

While there may be concerns about more such attacks, we tend to react the most during the initial stages, where emotion plays a bigger role. We do need to see this diminish though, and need it to keep diminishing to want to remain in, but we’ve already seen plenty of that and the expectation is that there will be plenty more to come on the down side.

Trading futures must be done with much care though, and when they tell you that you can lose more than you put in, oil has just shown us just how much more is possible.

The recommendations for shorting oil are out there, although with futures you don’t actually sell short anything but instead take the role of the seller of the contract and benefit when the price goes down, but we can’t just jump on a tip like this without ensuring that if we do get in, we get in at the right time.

Looking at the hourly chart of Brent over the last few days, a reversal has begun, and while this doesn’t mean that it will continue, we may not want to just bet against this either. We’ll know soon which direction we are going, but if we had to enter here, doing so long in the 64’s with a stop just below support may not be such a bad play.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

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