Oil: Don’t Get Faked Out By Fear

12/30/2011 7:00 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Fear has driven and sustained oil prices at elevated levels near $100, but a multitude of fundamental pressures are likely to cause a potentially rapid decline once the conflict in Iran cools down.   

We last wrote about the crude oil market in early November. At that time, we stated that the market internals did not justify the relatively high prices we were trading at and further added that we believed the $100-per-barrel resistance would hold and provide a ceiling to any attempted rally.

The market declined nearly 10% by the middle of December, and now, here we are again, back up to $100 per barrel.

See related: The Lone Factor Behind $100 Oil

As we mentioned previously, there’s a distinct fear bias in the crude oil futures market that always pumps a premium into prices. This fear bias has recently been fueled by several events in Iran:

  • First of all, Iranian students stormed the British embassy in Tehran as retaliation for new economic sanctions imposed upon them by Britain. The US and Canada also followed Britain’s lead

  • Secondly, the European Union imposed economic sanctions on an additional 180 companies and individuals, prohibiting them from conducting commerce with European Union members

  • Finally, Iran has threatened to close the shipping lanes of the Straits of Hormuz if economic sanctions are placed on their crude oil exports

Political games aside, the fundamental issues in the crude oil market can be seen in slackening demand, as well as the weakening internal market structure.

Global gross domestic product is sure to slow in 2012. The US is just beginning to gain some traction, and many economists feel that the best-case US outlook will see job growth keep up with population growth. This will leave us at historically high levels of unemployment, as stabilizing the workforce will not lead to wage inflation.

The problems in Europe have yet to be dealt with, and recent, credible comments point to a European Union “minus one small country.”

The European Central Bank continues to fight battles rather than implementing a strategy to win the war. The most recent example was the action on December 21, through which they lent more than $600 billion to 523 banks at an interest rate of 1%. The protection of private and corporate bank bad debt at the expense of settling sovereign debt issues is penny wise and pound foolish. The Bank’s inaction will lead to a European recession in 2012 and dampen crude oil demand going forward.

NEXT: Emerging Market Weakness Will Take Its Toll

|pagebreak|

The weakness in the EU has already begun to manifest itself in the BRIC markets. Brazil, Russia, India, and China are all slowing at a rapid pace. Their domestic stock markets have declined by an average of nearly 20% for 2011.

The International Monetary Fund expects that these countries will grow by 6.1% on average in 2012, and while this is more than enough to be jealous of, it still represents a decline of more than 35% from their recent high growth rates. The projected economic slowdown in BRIC countries can also be seen in other metrics including valuations, mutual fund outflows, and the implementation of easing policies as they attempt to engineer a soft landing for their slowing economies.

Finally, these expectations can be seen in the declining internals of the crude oil market. Technically, strong trends pick up new followers as they gain momentum. We noted in early November that crude oil had been losing market participants on each attempt to push through $100 per barrel. This continues to be the case with each test of resistance between the 50- and 200-day moving averages.

chart
Click to Enlarge

In fact, the crude oil market now shows the fewest market participants since August 2010. The market internals also show that commercial traders have been steady sellers at $100 per barrel and are willing to wait for a re-test of the $90 area to reassess their view of end-line demand going forward.

Therefore, we expect the crude oil market to fall rather quickly once Iran backs off its threats of blockading the shipping lanes out of the Persian Gulf.

By Andy Waldock of Commodity & Derivative Advisors

Related Articles on COMMODITIES