Understanding the Crude Oil Markets

Crude oil futures and oil stocks have one thing in common. They both trend well. Stocks have one advantage, they tend to have unlimited upside potential while the upside in crude oil is often limited because of supply and demand concerns. This and the leverage in the futures markets makes crude oil a difficult market to grasp for some traditional investors.

One of the first steps to take when considering an investment in crude oil futures is to learn how the market trades. Sure, it trends, but the trends are short-lived because of the weekly shifts in the supply and demand data. It is also often influenced by short-term geopolitical events such as the conflict in Iraq currently taking place. This often attracts speculators who disregard the traditional fundamentals and take positions based on what "can" happen. When it all is said and done, the supply and demand situation ultimately dictates which way prices are going to move.

Last week's trading action offered a prime example of how the crude oil market moves. Although the market reached a new high for the year, crude oil is in a position to close lower for the week because the military conflict in Iraq did not affect supply as speculated and the weekly Energy Information Administration supply and demand report showed an unexpected increase in supply.

Aggressive speculators tend to react to the news, but professional crude oil traders seem to only react when the actual supply of crude oil is affected. These professionals often sell overpriced crude oil to the speculators hoping for a short-term drop in price. Last week's price action seems to be suggesting that the price is more susceptible to "actual" higher supply rather than the "possibility" of supply issues in Iraq.

Earlier in the week, the U.S. reported a weaker-than-expected decline in first quarter GDP. This may be an indication that the economy is slowing. A slower economy is associated with a drop in crude oil demand. If the situation in Iraq remains stable then crude oil traders will focus on the economy and since the GDP indicates the economy may be weakening, crude oil is likely to correct.

Based on the rally from $97.30 to $107.50 over the past eight weeks, crude oil may be ripe for a pullback into a value area before the next rally begins. If you look at the rally from $89.73 in January, you can see that the market has been trending higher all year, but it has been subject to periodic retracements. These retracements are normal price corrections in bull market. They represent moves back to value-areas.

Looking at the current rally from $97.30 to $107.50, we have identified a value zone at $102.40 to $101.20. This zone will offer the best buying opportunity for trend traders and traditional investors. The market doesn't have to break back into this zone because besides the traditional supply and demand traders, the price action is also created by speculators.

If the situation in Iraq begins to effect supply then speculators will not wait for a break back into the value zone. They will buy at that market and prices will spike higher. But if you are an investors who focuses on the trend and the value, then waiting for a pullback into a fairly priced area may offer the best opportunity. Because the last two meaningful corrections lasted two weeks, one should give this trade suggestion a two week window to work out.