Monday, May 3, 2010

Is the oil bull running out of gas? Commentary: The crude rally is about to peak
By James Cordier & Michael Gross

TAMPA, Fla. (MarketWatch) -- For those busy watching equities, health-care debates or the latest unemployment data, you may not have noticed that crude oil has been in an aggressive bull market since February.

While much of the media focus has been on stocks and the "Is it real or is it Memorex?" debate, the energy markets have been quietly pricing in a global recovery. And perhaps it should be. Bulls have some solid data to back up their case.

The market is always right
While many doubted estimates that the U.S. economy would grow by 3% in 2010, recent data are making this appear more believable. U.S. employers added 162,000 jobs in March. The activity index for the nation's service industries rose to 55.4% in March from 53% in February. The National Association of Realtors says pending home sales rose 8.2% in February from January.

China, the world's second largest consumer of crude behind the U.S., saw GDP jump by 11.9% in the first quarter.

The world's first and second largest consumers of crude oil growing by 3% and 11.9%, respectively, should certainly not be a bearish development for crude prices.

Yet, one must remember that this market has spent the better part of 2010 pricing a recovery. And behind the scenes, one of the primary factors helping to drive the recent price surge was likely "old school" seasonal demand. That demand cycle, however, may be about to shift.

The irony of seasonal demand
There is a certain irony of seasonal tendencies in energies. It is likely that a good portion of the price gains over the past two months can be attributed to seasonal inventory demand by gasoline distributors. Distributors spend the springtime months accumulating inventories in order to have enough supply on hand to meet summer "driving season" demand.

This can often (but not always) result in price strength in crude oil and its products during the springtime months. However, distributors will begin easing back on inventory accumulation once they hit storage levels deemed adequate to meet the expected summer demand surge. This often happens in May or early June. Therefore, during this time period, it is common for demand at the wholesale level to begin waning.

As the Nymex futures contracts measure wholesale prices, it is not uncommon to see futures prices begin to recede, right at the exact time that demand at the retail level begins to ramp up.

In addition to seasonal tendencies, oil has a series of other bearish weights that combined, could begin to slow or even reverse, the current bullish course.

A) The "recovery story" is becoming old news. Oil was pricing in 2010 U.S. growth before the general investment community began buying into the story. Now, estimates for Chinese and U.S. growth are old news. The job of economic reports over the next several months will be to confirm that these views are on track. The oil markets seem to have already done a good job of factoring this expected growth into price. Thus, the potential for surprises would seem to be on the downside.

B) Supplies remain burdensome: At 353 million barrels as of the latest EIA estimate, U.S. crude stocks are near historical highs for this time of year and are now 7.1% higher than the five-year average.

2010 Crude oil stocks remain near historical highs for this time of year.

C) OPEC noncompliance: OPEC is running at 54% compliance to its own self set production quotas. This is a paltry figure even by OPEC standards. OPEC provides 40% of the world's oil. Key members such as Saudi Arabia, Qatar and Kuwait are said to be operating at maximum capacity. As the world's largest oil conglomerate, if you thought prices were going up later, would you be pumping oil as fast as you could right now?

Conclusion and strategy
While impressive in its velocity, it is our opinion that the rally in crude oil and products could reach a crescendo sometime within the next 30 days. While macro factors such as economic reports, a weaker dollar, or the standard geopolitical tensions could act as bullish counterweights, the cyclical pullback in wholesale demand could force the market to refocus on oversupply issues.

For those holding sizable positions in oil-related stocks or ETFs, May could be a good month to consider taking profits off the table. For the more aggressive trader looking to profit from a potential pullback, we continue to recommend selling call premium on the commodity itself.

James Cordier is the founder and Michael Gross is research analyst for Liberty Trading Group/, ( ) an investment firm specializing exclusively in selling commodities options. Cordier and Gross co-authored, The Complete Guide to Option Selling 2nd Edition (McGraw-Hill 2009). They do not hold any stock or ETF positions in this market.

*Fundamental Chart Courtesy of Hightower Research

** Price Chart Courtesy of CQG Inc.

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