I have mentioned a few times here that I believe that one of the keys to understanding short-term moves in financial markets is to understand that traders overreact. When your working life is focused on one commodity or currency pair, or maybe a handful of stocks, any news relevant to what you trade takes on exaggerated importance and overreacting is only natural. That means that for those outside dealing rooms, fading an initial big move and profiting from the retracement is usually a good strategy. I still stand by that, but sometimes news comes out that is, to quote Joe Biden a “big blanking deal”, and that is the case with oil prices when it comes to this week’s stories out of Saudi Arabia.
In case you missed it, the country’s ruler, King Salman, or more accurately his son, Prince Mohammed bin Salman, instituted a massive corruption crackdown last weekend that involved the arrest of many prominent Saudis and more have been detained this week, bringing the total to over two hundred. On the surface that looks like a good thing, but many are questioning the Crown Prince’s motives given that graft has been a normal part of doing business in the Kingdom for so long. The theory is that this is more about consolidation and even extension of power than it is about corruption.
That theory is supported by the regime’s shift to a much more aggressive stance on foreign policy this week. The Saudis have called for international cooperation against Iran “to combat terrorism” and have ratcheted up their hostility to Hezbollah controlled Lebanon, issuing a travel ban and recalling citizens from the country. The Saudis and Iranians have long been fighting proxy wars in Syria and Yemen for control in the region, but this week’s actions suggest that open warfare, or at least an extension of the proxy conflict, is possible.
Tension in the Middle East is nothing new, but the pace of the moves by Saudi Arabia this week is startling, and, as you would expect, had an effect on oil, at least initially. WTI jumped over 2.5% on Monday, but has since calmed down and even retraced a little. That retracement fits with the overreaction pattern described above, but in this case the move up looks to be anything but an overreaction, and buying on the retracement is the preferred trade.
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The increased likelihood of an open conflict in parts of the Middle East that have recently been relatively stable comes at a time when prices were already recovering as global demand began to pick up, and adding massive supply concerns to that demand story will add to that upward momentum. We have broken out of the recent ranges already and it is hard to see a quick return to below the $54-$55 level that marked has marked the top for over two years now. It is not that we cannot go down from here, it is just likely that we will form a new, higher range with $54 as the base, and if that is the case, buying on any retracement back towards that level and maintaining a long bias in oil makes sense.