A More Attractive Oil Trade

by: Wall Street Strategies

By Conley Turner

The volatility in crude oil prices has been pronounced of late as a confluence of factors has ignited concerns that the demand for the commodity may ebb. This has given rise to a situation where crude oil has become an attractive trading opportunity.

Among the reasons for the move down was a report by the Institute for Supply Management, which indicated earlier in the week that its service survey fell in April to 52.8 from 57.3 in March. While any reading above 50 indicates that the economy is expanding, the fact that it declined so dramatically suggests that the pace of the expansion is slowing. Providing even more impetus for the price gyrations was the fact that the U.S. Department of Energy reported that crude oil stocks rose by 3.4 million barrels in the previous week. The government agency stated that though imports declined, stockpiles were 2 million barrels more than the build of 1.7 million barrels that the market was anticipating.

Light, sweet crude for June delivery ended the week of May 6, 2011 at $97.18 after starting the week at $114, the highest level in about 2 1/2-years. Brent crude settled at $110.80 a barrel on the Intercontinental Exchange in London.

Despite the fundamental underpinning of the move down, some observers are also mulling the impact of high-frequency and program traders. There is growing sentiment that the entry of these market participants are operating in an environment not sufficiently equipped to handle them. This lack of human participation in trading has had a huge influence on the commodities market in the past and there is no evidence to suggest that such is not the case this time around.

The value of the dollar is also a critical factor to the move in oil. Among institutions, the weakening dollar trade has become as crowded in the same manner as precious metals investments, such as gold and silver, have become popular among retail investors. Since nothing goes up or down in a straight line, the current reversal in the value of the dollar was almost inevitable. The upside catalyst for the greenback came in the wake of European Central Bank's president Jean-Claude Trichet stating that he was not going to change Europe's interest rates. It was conveyed that there would not likely be any change for foreseeable future despite current inflationary pressures. With the dollar index moving higher against other currencies, crude and other commodities have come under considerable pressure. This price drop has also been exacerbated due to margin calls.

History has shown that such outsized price distortions can lead to a buying opportunity as the market tends to overshoots in both directions. Subsequent to the stock market's flash crash in May 6, 2010, it took approximately 2 months for equities to return to their pre- crash levels. The factors that had led to the increase in oil prices remain largely intact. The crisis in the Middle East and North Africa may not dominate the headlines as much as it did several weeks ago, but that situation still far from stable. Furthermore, the fundamentals regarding the U.S. dollar still point its value declining over the long haul. The ongoing Gross Domestic Product (GDP) expansion occurring in Asia is also likely to continue for the foreseeable future and provide buoyancy for ongoing demand for oil. It stands to reason that this event can be an attractive trading opportunity in the commodity.