Why It Could Be A Good Time To Short Oil

Sometimes I think that trying to trade a U.S. Energy Information Administration report is like opening a box of Cracker Jack. You never know what kind of prize you're going to get. That being said, oil prices surged over 4 percent on Thursday after the weekly U.S. inventory report showed a shockingly large drawdown in crude stocks.

According to the EIA, U.S. crude stocks dropped 14.5 million barrels the week-ending September 2 to 511.6 million barrels. It represented the biggest weekly decline in stockpiles since January 1999. Oil analysts expected to see a 600,000 increase.

Serving as proof it wasn't a math error, several hours earlier, the American Petroleum Institute said in its weekly report that U.S. crude inventories collapsed by 12 million barrels last week.

At least the API and EIA reports both showed a draw down. I don't know what would've happened in the markets if one had called heads and the other tails. Also the nearly 24 hour lag between the API and EIA reports gave short sellers a little time to head for the hills.

The EIA said that the huge drawdown was caused by Hurricane Hermine, which led to the closing of some U.S. oil production facilities as well as limiting imports and shipping. Data shows that Gulf Coast crude imports hit the lowest levels on record last week, even though the storm ultimately missed Gulf facilities.

I live on the Gulf Coast of Florida and watched the storm develop for 10 days. It didn't appear overnight so it surprises me that someone handling the weekly analyst surveys at the Wall Street Journal or Reuters didn't ask how the hurricane would affect the weekly EIA figures.

Despite the bad news, U.S. stockpiles still remain near record highs so this news is likely to correct itself in a week or two. For all we know, this move doesn't represent a change in trend. It was most likely triggered by massive short-covering with the "little guy" taking it the hardest.

Reports are already coming out saying that ships in the Gulf are already moving so we're likely to see a dramatic rise in crude oil stocks in next week's report. I don't blame anyone for missing the fact that the ships weren't moving as the storm was approaching after all who would want to stand out there watching ships unloading crude oil with a hurricane so close.

Now that the weather is clear and the ships are moving, I'll be looking for a fresh shorting opportunity on the charts this week. I think that with the huge domestic supply and OPEC and the other producers not close to announcing a production freeze, the bias is still to the downside.

Furthermore, the price action in the spreads suggests that the report is no big deal to the professionals. Only the small speculators seemed to be crushed by the news. The important crude oil spreads showed little change, confirming that this drawdown was a freak event.

Technical Analysis

(Click to enlarge)

Looking at the Weekly December Crude Oil chart, one can see that this week's rally while exciting on the daily chart, failed to change the weekly picture of the market.

The main trend is down according to the weekly swing chart. A trade through $50.59 will signal a resumption of the minor uptrend, but the main trend won't be reaffirmed until $53.62 is taken out. The trend will turn to down on a trade through the $41.58 main bottom.

The main range is $34.06 to $53.62. Its retracement zone at $43.84 to $41.53 is the major support. This zone stopped the selling the week-ending August 5 at $41.58.

The new short-term range is $53.62 to $41.58. Its retracement zone at $48.61 to $47.60 is currently being tested. Trader reaction to this retracement zone will determine the direction of the market next week.

Bearish counter-trend traders are going to try to stop the rally inside $47.60 to $49.02. This are going to try to turn the momentum back down in an effort to produce a potentially bearish secondary lower top. One may already be forming at $50.59.

The best indication that the selling is greater than the buying will be a break through the 50% level at $49.02.

Bullish traders are going to try to take out the retracement zone in an attempt to solidify the bottoms at $44.19 and $41.58. They may try to take a run at $50.59 then $53.62, but I think this will only be successful if there is an OPEC announcement.

Conclusion

We're not putting much support behind this week's reaction to the EIA report. Next week's report is likely to show a big stockpile build so this should put renewed pressure on prices.

We're looking at the raw supply and demand figures combined with the chart pattern and see room to the downside. We aren't sure if the selling will be strong enough to break through the $40.00 level before the end of the year, but it's looking more and more like we are going to trade in a range until the end of the year with last year's close at $43.83 acting like a pivot price.

The wildcard at this time is the production freeze proposal but we may not have to worry about that until the informal meeting between OPEC and non-OPEC producers near the end of September.