Futures

The Crude Oil Fear Premium

GabeVelazquez
Gabe Velazquez
Instructor

The most recent flare-up in the Middle East has (as usually happens) impacted the price of crude oil once again. This impact comes in two forms: an increase in volatility and a sharp rise in price.

Typically, crude oil, like most commodities is traded on projections of future supply versus demand, and this dynamic drives price on a longer term basis. There are times however, when the uncertainty of future shipments and disruptions in the flow of oil is so great, that traders and producers will anticipate a “worst case scenario” in the supply/demand equation and hedge against this uncertainty. This is what people in the industry refer to the “fear premium” and is responsible for anywhere from 8 to 10 dollars of  price increase from where it would trade under normal circumstances.    That fact is that even though we don’t import as much oil from the Middle East as we did say, 35 years ago, what happens in that region affects the price of oil globally.

The volatility spike has to do with the fear factor. With the constant media coverage, every sound bite,  and news release drives  traders to  react.  In the crude oil market, news acts differently than in other markets such as equities. This is because if a conflict is being resolved the implications are that oil will begin to flow freely again, and as a result prices will decline. Conversely, an escalation in a clash will drive prices higher because of the perceived disruption in supply.  Put another way, when oil has a fear premium,  bad news is bullish, and good news is bearish for the price of oil.

As is true with all markets, in oil, when everyone is convinced that it’s headed towards $200 a barrel and fear is so rampant that shorting is perceived as a fools game, that is precisely when the market is peaking.  This happens time and again.  The current  situation in Syria is fluid, and of course anything can happen, but if we look at a  longer term chart of crude oil we are approaching some major supply areas.

As we can see from the chart below, late on Tuesday, Crude touched daily supply, and pulled back about three dollars. There’s is a demand level not that far away, which suggests that much like in the month of July we could begin forming a new range.

CL Daily LFP 8-28-2013

In the longer time frame (weekly) we see that that there are 2 major areas of supply; one that we hit last Tuesday, and one just above.  So from a technical viewpoint it seems that the risk premium is largely played out.

CL weekly LFP 8-28-2013

 One other aspect of raising oil prices is the potential effect to stock prices.  Generally, there is a positive correlation between stock prices and oil. In other words, they mostly trade in tandem, but there’s a price point where the higher prices act as a tax  on businesses and the consumer at large, and that is where the price of oil and stocks tend to  diverge.  In  the past, huge price spikes in crude oil have acted as a damper to futures price gains in stocks.    Over the last week, stock prices have been under pressure  as the tensions in Syria intensify, and the media has directly attributed this situation to the decline.  The media always has to find the reason for everyday movements in the market, but we know that, ultimately all price movement is a function of supply and demand in the market place, therefore as traders, that is where our primary focus should be.

Regardless of the direction of the price of crude, the good news is that (for traders that have a viable, low-risk strategy, and are disciplined enough to execute it) this market will provide great opportunities in the weeks to come.  So if this describes you, then get ready. If on the other hand, this is not you; then you should steer clear until you acquire all of the above.

Until next time, I hope everyone has a great week

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.