Successfully Trading the Crude Oil Markets

Speculators versus Professionals

Last week's article highlighted the crude oil futures market and the roles that supply and demand as well as the major market participants play in determining the direction of prices. The article mentioned that unlike stocks, crude oil futures run in spurts. There may be a trend at times, but the trends are short-lived.

The upward price spikes tend to be driven by surprise geopolitical events like last year's weapons showdown between the U.S. and Syria and this year's military activity in Ukraine and Iraq. Speculators are usually behind these moves because they are trading off the fear that supply may be interrupted. Oil professionals work off of a different set of fundamentals like the Energy Information Administration's weekly supply and demand report.

Oil professionals in this case are individuals who buy or sell for companies who have an active interest in controlling the price of crude oil. Users try to get the lowest average price while sellers attempt to get the highest average price.

Some professionals use the futures markets to hedge against adverse price movements. They want to make sure their future usage is protected so they use futures contracts to assure they will be able to buy enough crude oil for future demand at a favorable prices. The worse thing that can happen to a company such as an airline is to have to go into the cash market during a price spike and pay up for the product they need.

The current situation in Iraq is a prime example of how speculators come into the futures market to drive prices higher in anticipation of supply disruptions and how professional hedgers use the futures to take advantage of price spikes that exceed expectations based on supply and demand issues.

Factors Driving This Week's Price Action

During the week-ending June 27, August crude oil futures stopped at $107.50 despite the presence of militants in Iraq seemingly ready to overthrow the government. That week, the news was peppered with stories of attacks or near-attacks on refineries in southern Iraq. Despite the stories, speculators couldn't take crude oil above $107.50 because of professional selling. Their job is to let the specs take the market higher, but then to assess the impact of a supply interruption in Iraq on the entire global supply and demand situation.

This week, Western Texas Intermediate crude oil fell for the sixth day on easing supply concerns in Iraq and Libya. With the fighting in Iraq contained to the north, the market is assuming that the southern oil producing area will not be impacted by the military activity. News that Libya was set to reopen two oil-exporting terminals also helped pressure prices.

Surprisingly, news of the first hurricane of the season actually helped push prices lower this week. Usually, a hurricane in the Gulf of Mexico will drive up prices because of its potential impact on refineries and oil traffic in the region. This hurricane, however, is expected to skim the East Coast. Crude oil prices felt a little selling pressure to end the week because Hurricane Arthur is expected to limit holiday driving which should have an impact on gasoline demand. Depending on the drop in demand for gasoline, crude oil prices may be affected later in the year because of lower demand from refineries.

While speculators tend to be more reactive to the news, professional traders tend to work with statistics and supply/demand tendencies. The Energy Information Administration (EIA) creates models that are used by most oil professionals. Their models are used to gauge the impact of a short-term event on the longer-term outlook for crude oil prices.

Models and Charts

The recent run-up in crude oil prices to $107.50 came close to reaching the $110.00 level, but looking at the graphic titled "Probabilities the West Texas Intermediate (WTI) crude oil price may exceed given levels" one can see that based on government statistics, crude oil had a less than a 5% chance of exceeding $110.00 per barrel in June. This information should've served as a warning to speculators to be careful about buying too close to $110.00. At the same time, it told the professional that this area may be a good area to start selling or hedging.

Successfully trading crude oil requires a combination of understanding factors that affect supply and demand and knowing value according to statistics or price charts.

Last week's article ended with a forecast for August crude oil futures. This week's article will end with the same chart because the chart pattern remains the same. Fundamentally, there was nothing bullish in the supply/demand data this week to alter the price chart forecast. Technically, the market weakened and appears to be poised to retrace 50% to 62% of the last rally like it did in March and April.

The best short-term price target zone on the chart is $102.40 to $101.20. This is likely to be the next buying zone for traders. It is not a bad area to consider sticking your toe in the water for the start of the next rally inside this value zone since the EIA report also says there is a slightly better than 20% chance that crude oil will trade above the $100.00 level for this time of the year.