Follow The Smart Money To See Where Oil Goes

Crude oil is set to post a strong gain for the week, boosted by a last minute decision by OPEC on September 28 at an informal meeting in Algiers to limit output. The initial thrust higher by the December Crude Oil market was very powerful, leading some to believe the move had set off the start of a new bull market. That opinion was likely held by momentum traders and non-professional investors who tend to be attracted to monumental moves in a market without really knowing the internal structure of the rally.

I am in the group who share the opinion that the proposal to limit production is full of holes that need to be filled before this market develops a sustainable rally. I still believe the market is over-supplied and given the history of OPEC and its previous failed plans to curb production, I am still skeptical that any such agreement will be followed long enough to put a sizeable dent in the huge global supply.

However, I am smart enough to know that I have to let the moves play out and not to fight the short-term momentum or the long-term trend if one develops. I'm not against this market moving higher or lower. But if I start to buy aggressively, I want to make sure I have big money behind me because I'm not capable of moving the market myself. This means I need to find out as quickly as possible if the price surge on September 28 and the follow-through move on September 29 was triggered by new buying or aggressive short-covering. This is because one is putting money into the market and the other is taking it out.

History has shown that rallies fueled by short-covering don't last very long. There needs to be real buyers in there to drive the price action. So over the next few days I will take a look at the order flow, the futures contract's open interest and the U.S. Commodity Futures Trading Commission's Weekly Commitment of Traders report.

This is important to me because as of September 23, data from the CFTC showed hedge fund managers cut their long position in crude oil to its lowest in a month, having made the largest weekly addition to their short positions on record.

If the new data shows that their short positions decreased on news and that their long positions increased then I will start to believe that the buying is real. I want the price action and the order flow to be in agreement. I don't want to get caught up in the noise of a surprise news event. It's a lot easier to trade successfully if prices are moving up along with volume.

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The main trend is still up according to the weekly swing chart and this week's price action indicates that momentum may have shifted back to the upside after a five-week setback.

The market is still reacting to the pair of retracement zones at $46.08 to $45.02 and $47.60 to $49.02. The former has been acting like support and the latter like resistance. These zone are very important to the structure of the market. If it continues to find support and resistance inside these ranges then we're going to see a sideways trade until contract expiration which corresponds with the OPEC meeting in November.

A sustained move over $49.02 will be the first sign, in my opinion, that there are real buyers in the market. A trade through $50.59 will signal a resumption of the uptrend. This would mean too much because $50.00 is a psychological barrier. However, if buying volume increases on the move then it could generate enough upside momentum to eventually challenge the high for the year at $53.62.

The inability to sustain a rally over $49.02 will signal the presence of sellers. The size of the seller will be determined by how hard crude oil breaks from this level. If there is a big stopper in there preventing a further surge to the upside then we could see renewed selling pressure.

The first sign that sellers are regaining control will be a sustained move under the 50% level at $47.60. This move would just about guarantee we are in a rangebound market because the next downside target is another 50% level at $46.08.

Essentially, I'm looking for a strong upside bias on a sustained move over $49.02 and a strong downside bias to develop on a sustained move under $47.60.

Conclusion

OPEC's decision to agree on developing a plan to curtail output may have ignited the spark needed to trigger the start of the next leg up in the crude oil market. However, with uncertainty surrounding the plan, I'd like to verify that the price action the past two days is being support by a shift from short to long by the hedge funds. I feel that if this move is going to develop into something major, there must be good structure at its start.

If the hedge funds have shifted from short to long then I would like to be long and wouldn't mind buying strength. If the hedge funds haven't make any sizeable adjustments to their short and long positions then this will tell me I still have time to buy and that the market is likely to pullback into a value zone before moving higher.