Year-End Oil Event Few See Coming

11/11/2011 9:00 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

While most are expecting crude oil to rally from the October lows, record bearish sentiment and declining futures volume could result in a new leg down instead.

Many of you may have noticed that gasoline prices have moderated since the Labor Day holiday rally. This is typical seasonal behavior, however, I think there may be more room to the downside rather than a rush back to the highs in time for Christmas travel.

One thing is for certain: commercial traders’ actions clearly reflect their negative bias in the crude oil market.

Commercial traders sold nearly 22% of the positions they picked up on the market’s decline to $75 per barrel in early October. This type of selling extends beyond simple profit taking. They are clearly placing bets that resistance around $100 per barrel will hold.

This is the exact opposite view that commodity fund managers and the retail money they allocate have of the crude oil market.

Steve Briese, author of The Commitment of Traders Bible, has devoted 20-plus years to tracking the Commitment of Traders (COT) reports and he noticed an anomaly in this week’s reporting.

See related: Find Useful Signals in the COT Report

His analysis was based on adding in the long-only positions of commodity index traders. These are the fund managers who maintain the balance of positions for commodity-based exchange traded funds as well as the Jim Rogers-type funds, which invest directly in the futures markets.

Adding their long-only positions to the crude oil market shows that commercial traders have actually set a new net-short record position. Commercial traders have sold more forward production at these prices than ever.

Clearly, we have come to a tipping point. Retail investors, through their purchases of commodity fund shares, have swallowed up the 47,000 contracts that commercial traders have sold.

In spite of the size of these positions changing hands, we’ve seen the total number of outstanding contracts decline by nearly 20% since the peak in May. This decline in open interest while the market is climbing is widely viewed as a technically weak move.

Finally, I’ll throw in a wild card: declining retail interest in the futures markets.

Every market has a directional wild-card bias. The crude oil market has a built-in fear bias to the upside based on potential supply disruptions. This may be the first time I’ve really considered a negative bias in public sentiment in this market.

This is based solely on the MF Global implosion and the heinous nature of their commingling of segregated funds.

MF Global customers’ trading account cash was supposed to be 100% separate from MF Global’s operating cash. That is the purpose of segregated funds. Customer funds are always protected regardless of the brokerage firm they clear through. John Corzine, who once held the trust of the entire state of New Jersey, has broken the trust in this principal and possibly, the retail investors’ faith in the futures markets.

The withdrawal of retail market participants in the futures markets will force the long-only commodity index funds to liquidate positions to maintain the proper portfolio allocations as retail customers make redemption requests.

Given the record speculative long interest, we could see a selloff in the crude oil market similar to the 2008 correction of more than 50%, or at least a re-test of the October lows at $75.

By Andy Waldock of Commodity and Derivative Advisors

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