The Technical Trend Is Down But Is A Turnaround Coming Soon?

Last week, OPEC triggered a sell-off in January Crude Oil when it decided to refrain from making a production cut. The almost 10% break in prices was triggered by sell stops from those speculators taking long positions going into the meeting and from a handful of new short-sellers.

Those taking a long position were betting on a cut in output. The number being tossed around by traders ahead of the report was a cut from 30 million barrels per day to 29.5 million barrels per day. The size of this expected cut probably wasn't going to be enough to stem the price slide over the long-run, but it probably would have been enough to give the short hedge and commodity funds an excuse to book profits and take to the sidelines until the next selling opportunity emerged.

The handful of new shorts who reacted to the report are most likely still short because the fundamentals haven't changed and the technical trend is still down. Even with those two factors on their side, these traders are not without risk.

The purpose of this article is not to pick a bottom, but to find areas on the chart that could make the short traders who sold late in the move run for cover. Keep in mind that before a market begins a rally, something must happen to drive the short-sellers out of their positions. This is the next move that should develop. Once we get a bona fide short-covering rally going in the crude oil market then traders in gasoline futures and energy stocks should follow suit with their own short-covering rallies.

Last week, we noted that crude oil was probably closer to a bottom than the start of a new leg down. This was determined because of the size and duration of the break in prices since June. Had the OPEC decision occurred when crude oil was near a top then we would've looked for the start of a break, but since the market was already trading near multi-year lows, we assumed that the OPEC decision was already priced into the market. This is often called a "sell the rumor, buy the fact" situation by veteran futures traders.

Also supporting the notion of a "no" decision by OPEC were the various quotes from the more influential OPEC members such as Saudi Arabia and UAE who basically said they would do nothing to production at this time and allow the market to find its own support level.

When predicting that "we may be within days of a massive rally in prices", we weren't looking for the rally from the $63.72 to $69.54 on December 1, we were looking for something larger. We did identify the key support area as $64.00 to $63.00 so we weren't that far off in price. We can conclude that we were pretty close on price and time, but what is still unknown to us is the developing bottom pattern and the fundamental catalyst for a rally. This is where speculation comes in and why we are still sticking with our initial limited risk strategy of exploring the long call option market in anticipation of an even bigger rally.

Why did crude oil stop at $63.72 on December 1? The easy answer is more buyers than sellers. This means that the short funds probably decided to cover some of their shorts. It may have been triggered by a decline in offers coming into the market, or increased size on the bid. These are the reasons that technically based traders are seeking. Fundamentally speaking, there are others.

One reason for the turnaround may be that the market was being defended by U.S. producers as prices may have been nearing a critical level that makes their operations unprofitable. After the OPEC decision, it occurred to some traders that the decision to refrain from a production cut put the burden of preventing a further decline in price directly on the shoulders of the U.S. producers.

In hindsight this makes sense because of the pre-meeting stance Saudi Arabia, the OPEC leader, was taking. It wants crude oil to find its own support this time. They don't want to be the entity setting the bottom of the market. Furthermore, it may have an idea that if U.S. companies continue to produce oil at current levels, they will price themselves out of the market.

With this scenario at the forefront, we are going to be watching U.S. production levels very closely in each week's Energy Information Agency report because it may tell us if U.S. output is beginning to trend lower. This will be one of the first clues that U.S. producers understand OPEC's message loud and clear. The EIA supply/demand reports are released every Wednesday at 10:30 a.m. ET.

Secondly, we are going to watch the Commodity Futures Trading Commission's Commitment of Traders report. The latest report released on December 1 showed that futures market traders and large speculators slightly trimmed their overall bullish positions in crude oil futures on November 25, just a few days before the OPEC decision. The latest report due out on December 5 will reflect trader assessment of the market conditions now that OPEC has refrained from a price cut. If the report shows an increase in bullish positions then we could be looking at the start of a rally.

From a technical perspective, the reversal chart pattern on December 1 has put in a temporary bottom at $63.72. This is the level where short sellers began taking profits and aggressive speculators started buying.

This is a potentially bullish chart pattern, however, there has to be a follow-through rally to confirm the pattern. If there is going to be a rally, then buyers are going to probe the upside to see if they can encourage more short-covering in order to launch a strong rally.

Taking out the first level at $69.54 will confirm the initial pattern. Overcoming $70.78 will put the market on the strong side of a key 50% level. The level that will determine that the OPEC decision has been fully absorbed by the market is the closing price the day before the decision at $73.69.

This level is important because overtaking it will mean that those who sold into the decision are trapped at low levels and may be willing to pay anything to get out. This is how big rallies start.

The failure at any of these levels will mean that there is still enough selling pressure in the market to prevent a meaningful rally. It will not necessarily mean a new low is coming. If this occurs and buyers and sellers are locked then look for a sideways trade. This is why considering a long call strategy at this time is the best way to approach the market. It offers limited risk and unlimited upside potential.