Where Oil Can Go From Here

Crude Oil Outlook

If you read the crude oil news on January 29, the day that crude oil bottomed, you'll notice that much of the credit for the closing price reversal bottom on that day was attributed to upbeat economic data from the U.S., namely a better-than-expected first-time claims for unemployment benefits. Apparently, this ignited hopes of growth in demand for oil.

It also came on the day that the Federal Reserve's monetary policy committee announced that it would leave interest rates unchanged while reiterating its pledge to remain patient in its efforts to normalize monetary policy. The Fed also issued a solid assessment of the economy. Once again, the news pointed to the possibility of increased demand.

Both news events occurred the day after the Energy Information Administration showed in its weekly crude oil report that stockpiles in the U.S. surged more than expected the previous week. According to these figures, inventories had reached an 80-year high. The report showed that U.S. crude oil stocks rose by 8.9 million barrels that week to a record 406.73 million barrels.

If you put these events together, one would have to conclude that the news writers believe that demand is going to stabilize the oil market and trigger a rise in prices, but in reality, we all know that the sell-off in the market has been driven by excessive supply. Demand is a very small part of the equation at this point. This is another reason why as a serious trader you have to look at the "internals" to determine what is actually going on in a market. These internals include information that is often overlooked by the average speculators like the number of working oil rigs.

On Friday, January 30, crude oil settled up 8 percent. At the time, this was its best day since June 2012. The catalyst behind the move was data which showed U.S. drillers were curtailing their activity in the shale drilling boom. Reports were surfacing that showed oil companies were making further cuts to capital expenditures while taking more rigs offline.

According to oil field services firm Baker Hughes, U.S. rigs in operation fell by another 94 during the previous week. Additionally, Canadian producers took another 11 rigs offline. Historical data showed that the weekly drop in the rig count was the most since 1987. With about 24 percent of the oil drilling rigs taken out of service, the selling pressure dried up and speculators started buying while shorts started covering in anticipation of a slowdown in U. S. oil production.

Although the rig count news may have been the spark this market needed to encourage short-covering, the crude oil market is still oversupplied by about 2 million barrels. The conflicting fundamentals may be creating uncertainty. On one hand, the market is still oversupplied, but on the other hand, producers have taken steps to curtail output. This is the point at which demand comes in.

If the economy continues to improve enough to use up the excess supply then, coupled with the production cuts, the supply and demand situation could create a bullish scenario. The key for traders at this time is to figure out how long it will take for the economy to use up the excess supply. This is difficult to calculate and hence the volatility.

When the fundamentals were clear, i.e. overproduction, shorting the market was almost a no-brainer for most trend traders. There was direction on the chart and bearish fundamentals. It was a perfect storm for the largest trend traders, the commodity and hedge funds.

Before a market shifts from bearish to bullish, there must be a transition period. The current chart pattern suggests that this is what we may be going through at this time. There are going to be some funds that cover at all costs and other that will try to finesse their way out of their short positions. To put it another way, some funds will cover shorts at the market and the sellers will keep asking for higher and higher prices until that round of selling is over. The next round of buying or short-covering comes in on the break back towards the major bottom. This appears to be how we are going to end this volatile week.

If you look at the daily chart, you will see a rally from $43.58 to $54.24. This is the rally which drove out the weaker shorts. This range created a retracement zone at $48.90 to $47.63. If this area holds as support then this will be a sign that new buyers are coming in.

If the buying is strong enough then these traders will drive the market into $54.24. Strong upside momentum, coupled with better-than-average volume will make short traders uncomfortable, forcing them to cover at higher prices.

Strong short-covering coupled with even stronger buying on a move through $54.24 could create enough upside momentum to trigger an eventual move into the intermediate retracement zone at $61.62 to $65.87 and into the primary upside target at $67.75 to $73.45.

The scenario will develop if buyers continue to support the $48.90 to $47.63 area. If this area fails then look for a retest of $43.58 over the next few weeks.

In conclusion, U.S. producers have done just about all they could to slow down production. Now it's up to demand to use up the excess supply to bring the supply/demand picture back to normal. This puts the emphasis on the economy and that starts with Friday's U.S. Non-Farm Payrolls report. In order to support a rally, the economy must continue to improve or it is going to take a long time to overcome the current oversupply situation.