Oil - I'm Calling Your Bluff

Includes: SCO, USO
by: Tomasz Zaton

Political unrest in the Middle East pushing oil prices higher.

Short-term disruptions are priced in.

Perfect spot to short oil based on contrarian approach.

Oil is trading at 2-year highs - front month WTI future is approaching "good old times" level of almost $60 per barrel. Everything seems to be working for oil and recent political events in Saudi Arabia managed to push oil even higher. So are we about to see even higher prices?

First, let's review some basic facts about oil. Global day to day demand is relatively stable with millions of entities buying and consuming oil. Oil production, however, is highly concentrated. Russia, Saudi Arabia and the US each produce over 10% of global total volume. Looking specifically at the Middle East, we then have Iran (5% of global production in 2016), Iraq (5%), United Arab Emirates (4%), Kuwait (3%), Qatar (2%) and Oman (1%).

So Middle East countries account for roughly 1/3 of total global production. The region is inherently unstable with so many complexities and local rivalries that sometimes it is difficult to comprehend. Moving further, there are a few African countries contributing over 1% of global supply that are much less stable than Western liberal democracies. What else? Weather conditions (think these deep-water oil platforms far in the open sea), hurricanes, political unrest, pipeline attacks, port closures, terrorism and other factors can all sharply influence oil prices in the short term.

Disruption in one of these countries could take thousands of barrels of production out of the market just like that. No wonder why oil trading is pretty wild. Up 6% in 2 hours due to an escalation of a specific conflict, then down 4% in 30 minutes because the situation improved - these are the regimes of volatility you have to be ready to embrace if you pursue oil trading.

And institutional oil traders know all this like you know your way to your local grocery store. The situation in key geographic choke points like the Strait of Hormuz, the situation in volatile regimes of the Middle East - while individual traders might rely on front page news, professional guys know events as they unfold. What's more, they anticipate them. Therefore, short-term disruptions are to some extent always priced in.

Given all the factors above they have to be. That's a fact of life. It is simple as that. This is why making trading decisions based on short-term factors puts you in a great disadvantage. Are you relying on TV news while making your oil trading decisions? Forget it, you already lost. Oil trading is among the fiercest competitive endeavours known to humankind.

Recent events in Saudi Arabia gained a lot of traction in the media, with many commentators proclaiming the start of a new bull market. Is it really so? For starters, let's go back to winter of 2016. Iran was entering global markets again and oil prices were dropping like a rock in anticipation of its ramped up production.

The front month WTI oil future reached its multi-year low of $26. Oil was literally cheaper than water. Everyone was bearish. The speculative net long position as defined by CFTC was at extreme lows. And what happened? After a brief plunge, spot oil prices recovered by almost 100%. The Armageddon never happened.

What is the situation now? Oil futures seem to be breaking out of a range, with the European benchmark (Brent) approaching $63-$64. Looking at the futures curve - the December 2017 WTI future increased by 50% from a bottom of $38 in January 2016 to $57 where it is trading right now. So we could say that a lot of the bull market already happened. And why not? Economies are ticking along; it seems there are no dark clouds over the horizon. On top of this, the political situation in the Middle East worsened pushing up oil prices. So there are a lot of positive factors out there - I do not deny that.

I just want to remind that similarly to today, oil markets also had everything going for them in the summer of 2008. And then oil collapsed from $150 to $30 in a few months. Quite a ride. Therefore, I would be looking to establish a contrarian position and short oil. One additional factor (apart from the news-related price spike) that convinces to do so is the fact that the speculative net longs in the futures markets reported by CFTC are very high again.

Will my call be proven right? I do not know. If you are however looking for a contrarian trade, then shorting oil via the United States Oil ETF (NYSEARCA:USO) - or buying the inverse oil ETF the ProShares UltraShort Bloomberg Crude Oil (NYSEARCA:SCO) - might be the trade for you. It is likely that we are witnessing a top in the oil prices.

There is an extremely bullish sentiment, prices have risen substantially in recent weeks and the political risk just unraveled. It simply does not get better for oil bulls. These are the conditions that often mark the end of bull markets with all the obvious factors pointing to higher prices and no one thinking about the potential downside.

Yes, oil - I am calling your bluff.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.