The spike in May NYMEX Crude Oil futures during the pre-market trading session on Wednesday night (Eastern Time) came as a surprise to many traders because, let's face it, most have us had been lulled to sleep reading about oversupply and rig counts since OPEC decided in late November that it would not support another production cut.
Based on the size of the rally and the subsequent "give back" during the regular session trading hours, it looks as if many traders were unprepared for the news and shifted to panic mode when the news that Saudi Arabia had bombed the Iran-backed Shiite rebels who are taking over neighboring Yemen, hit the market.
Those selling into the rally may have reverted back to the traditional supply and demand fundamentals governing the market. They may have also forgot to do their homework as to why this incident is different from the fighting in Libya, Iran and Syria.
Let's face it, for almost two years, traders have not reacted to bombing and fighting in the Middle East. If memory serves me right, the last time military action drove the crude oil market higher was in September 2013 when President Obama threatened force against Syria. There was also a similar threat made in September 2012.
After those threats were made, the crude oil market seemed to settle down with traders focusing on the growing oversupply situation. Even when rebel fighters neared Baghdad, the market hardly blinked because we learned at that time that the refineries…
The spike in May NYMEX Crude Oil futures during the pre-market trading session on Wednesday night (Eastern Time) came as a surprise to many traders because, let's face it, most have us had been lulled to sleep reading about oversupply and rig counts since OPEC decided in late November that it would not support another production cut.
Based on the size of the rally and the subsequent "give back" during the regular session trading hours, it looks as if many traders were unprepared for the news and shifted to panic mode when the news that Saudi Arabia had bombed the Iran-backed Shiite rebels who are taking over neighboring Yemen, hit the market.
Those selling into the rally may have reverted back to the traditional supply and demand fundamentals governing the market. They may have also forgot to do their homework as to why this incident is different from the fighting in Libya, Iran and Syria.
Let's face it, for almost two years, traders have not reacted to bombing and fighting in the Middle East. If memory serves me right, the last time military action drove the crude oil market higher was in September 2013 when President Obama threatened force against Syria. There was also a similar threat made in September 2012.
After those threats were made, the crude oil market seemed to settle down with traders focusing on the growing oversupply situation. Even when rebel fighters neared Baghdad, the market hardly blinked because we learned at that time that the refineries were in the other direction. And that information was the key to understanding why crude speculators were not reacting to the threat of military action.
It seems that traders have gotten used to unrest in the Middle East and speculators have gotten burned waiting for a big price spike. The reason one never took place was because while these threats were taking place, the supply of crude oil was never threatened or disrupted.
Flash forward to November 10, 2014 when the U.S. Energy Information Administration published a report called "World Oil Transit ChokePoints". In this report, the EIA said, "World chokepoints for maritime transit of oil are a critical part of global energy security. About 63% of the world's oil production moves on maritime routes. The Strait of Hormuz and the Strait of Malacca are the world's most important strategic chokepoints by volume and transit. "
This is good information to know in case there is military action in these two areas, but at this time, we should be concerned about number four on the list: the Bab el-Mandeb Strait. Although Yemen isn't known as a major producer of oil, it is in close proximity to the Bab el-Mandeb Strait and a closure of this transit area could prevent oil tankers from the Persian Gulf from reaching the Suez Canal and blocking the quickest route for tankers from North Africa to Asia.
Based on news reports about this region, bearish traders should be concerned about their positions because the bombing of Yemen is not expected to be a one-time event. It may develop into a longer-term event because Saudi Arabia has vowed to do "anything necessary" to deter the rebels out of Yemen in order to keep the transit routes open.
Although May Crude Oil did give back much of its gains on Thursday when cooler heads prevailed, the situation isn't over yet. Some short-sellers are treating the rally as another opportunity to build their bearish position. They may feel that the U.S. has enough oil in storage to ride out the situation. To some, the risk for an oil supply disruption because of this event may be low, but crude oil is a speculative market and speculators will react differently when seeing headlines that mention the possibility of supply disruptions.
The proof that speculators may have already moved beyond the fear of an oversupplied market was seen on Wednesday night when the crude oil market surged nearly 4% just 12 hours after the EIA weekly inventory report showed a larger-than-expected increase in U.S. oil inventories. This report showed that inventories increased for an 11th straight week by 8.2 million barrels for the week-ended March 20.
At this time, traders have four choices. The first is to cover all short positions and go flat. The second is cover all short positions and take an extremely speculative long position. The third is to lighten up on their short positions and the fourth is to continue to initiate new short positions on the rallies while waiting for the conflict to end.
All of these suggestions carry a specific risk/reward relationship that you should try to match to your personal trading style because at this time, there is no right answer when a news driven market emerges.
Before making a decision, keep in mind that volume and volatility are expected to increase during this developing crisis. Also keep in mind that you should have an exit strategy in place before taking on any new positions or deciding to add to current positions.
If looking at the weekly chart, the main trend is down and will remain down unless $56.08 is taken out with conviction. If still short on this move, you risk a run all the way up to $71.45. Based on the first rally from the $44.03 low, the price action on Thursday completed a normal 50% to 61.8% retracement.
The main trend is also down on the daily chart. In this case, the short-term range is $54.00 to $44.03. The spike to the upside took out its retracement zone at $49.02 to $50.19. Trader reaction to this area should set the tone for the near-term. If buyers build a support base over this zone then look for the rally to extend into at least $54.00. Overtaking this price will turn the main trend to up on the daily chart.
If $54.00 is overcome then look for buyers to challenge the main top at $56.08. This is the potential trigger point for a huge rally because not only will the buying take out a series of tops, but it will also cross to the bullish side of a major downtrending resistance angle.
Conclusion
Traders have to be concerned about the developing conflict between Saudi Arabia and Yemen because a major transit area is at risk. If the military campaign lingers then speculative buying will continue to drive the market higher.
There may not be a reason for U.S. traders to panic because we have an oversupply of oil, however, this oil is not available for global consumption. Therefore speculators will likely use the headlines to continue to press shorts out of the market. This may eventually lead to a change in trend to up on the daily and weekly charts which will subsequently trigger further upside action.
The size and duration of any short-covering or speculative buying rally will all depend on how swiftly Saudi Arabia can gain and maintain control of the Bab el-Mandeb Strait.