In August 2006 the oil price, West Texas Intermediate, reached an all time high of around $80 per barrel. This rally had been driven by the war between Israel and Lebanon in June and July. Also, the hurricane season had put upward pressure on oil prices.
When the conflict ended and peace returned, the oil price was starting to drift lower. Following that peak, the WTI August contract began to descend sharply touching a bottom of around $55 at the beginning of the year. Since my column of May 29, WTI has now rallied by about 6% to reach the barrier of $70.
As I mentioned in my last column, the Dubai Mercantile Exchange took the initiative to open its doors to the oil trading business on June 1. Although the characteristics between Oman Crude Oil, WTI and the European Brent Crude are slightly different, the prices are to a certain extent correlated to each other. The same fundamentals apply to these commodities. Political tension in the world, hurricanes and strikes in oil producing countries will put pressure on all oil prices.
To hedge or not to hedge
Oil futures contracts can be traded around the world, and around the clock, from Dubai to New York and London. Nowadays, it is as easy for you to do shopping in a supermarket next door as to buy a barrel of oil. There are several ways to profit from developments on the oil market. One way is to take a directional position: long or short.
Being long, one is speculating on rising prices. Being short, one is betting prices will fall and that the contract sold can be bought cheaper in the future. Nothing is more difficult than to predict stock prices and, moreover, commodities prices are being influenced by many fundamental developments. Unexpected developments in the world, for instance, a coup in Venezuela, a strike in Nigeria or increased tension in the Middle East can have a severe impact on oil prices. Just last week, oil prices spiked 3% after Nigerian labour unions began strikes to protest against an increase in domestic fuel prices. This then led to a disruption of oil production and Nigeria is one of the largest exporters to the US.
It is advisable not to have SEC overnight positions in the futures markets, unless your wallet is deep enough to bear some draw downs. A possibility is to hedge a long position in, for example, Oman Crude Oil with a short position in Brent or WTI. Since the correlation is not always 100%, depending also on the liquidity of both contracts, it is not guaranteed that the position is perfectly hedged.
Since there are several contract months listed on the futures exchanges, another strategy can be initiated: a calendar spread. For instance, a WTI August Long and a WTI September Short. At this moment, WTI August is traded at $69.2 and the WTI September at $69.9. Hence the spread is $0.7. It is interesting to see that the August/September spread was traded at $0.4 in March and rose to $1.1 in May. As you can see, to be in a spread position, does not mean that your position is flat and cannot move against you.
Front months and back months
Under normal circumstances, in oil, the front months are cheaper than the back months. That is called a contango market. The reversed situation is called backwardation. In this case front months are traded at higher prices than the back months. It is also possible that, due to hurricanes, the shorter term futures like WTI August are rising more sharply than September, October or even December futures. In the commodities markets, balance of supply and demand in the underlying commodities are extremely important aspects to monitor. Recently, in the US, due to bad weather, the soya bean crop has been largely destroyed. This resulted in a sharp rise in the shorter contracts. This could also happen in the oil market when a big hurricane the size of Katrina visits the US again.
The market is preparing for the driving season and the hurricane season in the US. The North Atlantic hurricane season runs from June to November and has produced an average of 12.5 storms annually since 1990. Hurricanes Katrina and Rita struck the Gulf of Mexico during the record 2005 season and caused $17bn worth of damage to oil and gas pipelines, production platforms and refineries. Prices usually peak this time of year and there has been a major shift in sentiment in recent weeks, with investors paying less of a premium to hold later dated oil contracts. In other words, in case hurricanes cause less damage than expected, this risk premium will diminish, resulting in lower future prices.
Oil to all time high?
The question is if WTI oil reaches an all time high of around $80 again. Nobody can look into the future so it is difficult to tell. What we can do is to take a look at the technical situation of WTI. Supported by the fundamentals, WTI could try to attack that level again. With a current price of $69.2, WTI is trading near a short term resistance level. A pull back to around $64 and $66 is possible and if this level stands firm and holds, a new rally could be unleashed; provided that the resistance at $70 is taken out, the way is clear to $80. The situation will turn negative, however, if WTI sinks below $64. Besides looking at charts, it is also highly advisable to watch weather forecasts as well.