Investor Sentiment Could Be Shifting

A drop in U.S. crude oil production helped drive futures prices higher this week. There is even evidence of renewed hedging in the deferred futures contracts that suggest the bottom has been made.

The slowdown in U.S. crude oil production is the key to sustaining the rally since excessive production was the driving force behind the tremendous price slide. The recent inventory figures suggest that cutbacks in oil production and oil exploration may finally be taking hold. U.S. production fell for the second time in three weeks and refinery runs are spiking higher indicating increased demand. Market participants seem to be indicating that they believe that U.S. production is slowing, at least for now.

The recent Commitment of Traders data released by the Commodity Futures Trading Commission also indicates a possible shift in investor sentiment. The report covering the March 31st to April 7 time period showed that speculators increased their overall bullish bets.

The non-commercial contracts of crude oil futures saw a weekly change of +25,348 contracts to total a net position of +252,043 contracts. Long positions in oil futures increased by 4,901 contracts, while the short positions fell by 20, 447 contracts.

Despite the rally, the market remains oversupplied according to most fundamental analysts, but the price action and chart pattern suggest that traders still haven’t taken out enough of the weaker speculators holding on to short positions for this very reason.

A sustained rally could drive these speculators out of the market. While the current rally has been slow and steady, producing an almost perfect “W” chart pattern, crude oil may be in the window of time where the panic buying starts as shorts may be forced to scramble out of their positions. When a situation like this develops, these shorts will pay almost anything just to get out of their positions. This action will trigger a price surge and at the same time present better prices to attract fresh shorting pressure. This is why any rally is likely to be limited.

Speculators shouldn’t be looking for a strong surge based on normal supply/demand analysis because it takes time to figure out what the usage rate is. In other words, analysts are going to have to figure out how much the U.S. is producing and how much demand there is in order to determine inventory targets. Given the nature of the crude oil market, all it is going to take is a disruption in supply to trigger a short-covering rally and to attract speculative buying.

One story breaking late this week that could be the speculative event to fuel such a surge is the news that a tribal group made up of former Al Qaeda militants took control of a major southern oil terminal in Yemen after military forces protecting it withdrew from the site. If this action is found to have an effect on supply then we may have the ingredients needed for a breakout rally.

The chart pattern looks promising for June Crude Oil futures. While the set-up is there for a strong upside breakout, we can’t predict if the volatility will be there to drive it higher. It is going to take some strong buying and short-covering over the near-term to reach the two identifiable objectives.

Based on the main range of $93.31 to $45.93, one objective is its retracement zone at $69.62 to $75.21. The trigger point for this move is the swing top at $57.27. Earlier this week, buyers took out this top with a drive into $57.92, but the rally failed and the market pulled back. This tells us that something in the fundamentals has to happen to fuel a sustained move.

This price action typically indicates that the breakout was triggered by buy stops and short-covering rather than fresh buying. This makes sense because after all, who would buy strength with all this supply sitting around? Nonetheless, if there is a shift in the fundamentals or a panic situation, aggressive speculative buying and short-covering could drive this market sharply higher.

This weekly chart shows that there is plenty of room to the upside with the primary objective $69.62 to $75.21.

The second objective is determined using conventional chart pattern analysis. The last break from $57.27 to $45.93 was $11.34 in 4 weeks. If we add $11.34 to the top at $57.27 then the objective of this double-bottom chart pattern is $68.61.

Based on this analysis we have to conclude that there is a possibility of a rally into $68.61 to $69.62. We can come up with the objectives on the chart, but we don’t know the catalysts or the events that could trigger the breakout rally.

As traders, we would like to see strong upside momentum on a breakout over $57.27, but this is dependent on volatility which is, understandably, very difficult to predict. Forecasting the timing of events is also difficult so we have to conclude that a gradual reduction of supply will probably encourage more short-covering, fueling a slow, but steady grind into our objectives over the near-term.

Keep in mind that it took 3 weeks for crude oil to rally $10.59 from $46.68 to $57.27 and another 4 weeks to rally $11.99 from $45.93 to $57.92. Given this scenario, it may take a sustained move of 4 weeks or more over $57.27 to reach out objective of $68.61 to $69.62.

Now that the fundamentals are in place and the crude oil market has formed a double-bottom, there has to be something that triggers a breakout of its current supportive base. The chart pattern suggests there is room to the upside, now all we need is a reason to encourage more short-covering and to attract speculative buying. It looks as if traders will be watching the news next week besides the supply and demand reports for reasons to extend the current rally.