Crude Oil Is Headed Lower

 | Oct 11, 2013 | 3:00 PM EDT
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Crude oil prices have been hovering above $100 per barrel since July. The initial move into triple digits was sparked by an Egyptian coup, but it was tension in Syria that kept prices afloat for the longer term. Following the political events of this summer, we were expecting what we view as "fluff" to come out of pricing.

Although it has taken much longer to materialize that we anticipated, the market isn't disappointing us. Crude oil has fallen from the $110-per-barrel area, to a low of about $100 and appears to have room to continue moving lower. We are targeting the $96 area initially, but prices could easily reach the low $90s.

Source: QST

There are a few compelling arguments that support the bearish view. For instance, crude oil prices seasonally experience weakness from mid-October through mid-December. Analysts explain the tendency as a tapering of fuel consumption following the summer driving season as well as through the winter weather months.

Another bearish argument is the fact that most speculators are already net long the market. In fact, the "large trader" group of the CFTC's COT Report -- considered to be the smart money -- is holding near-record net-bullish positions. At some point, the long speculators will opt to liquidate and that can only mean one thing; lower crude oil prices.

Another thing to consider is the massive backwardation priced into the crude oil futures markets. In a normal market, described as contango, the price of near month futures contracts will be higher than that of distant expiration months. This is because there is a "cost to carry" crude oil prior to delivery; in other words, crude set for delivery in the future should be valued at a higher price because the holder of the crude must pay for storage and insurance between now and the future delivery date.

In today's market, futures contracts with closer expiration months are trading at a higher price than that of contracts with more distant expiration dates. This is an abnormal environment and likely won't persist for long.

The inversion can be explained by expectations of supply disruptions at the hands of the Middle East and strong short-term demand, but it will likely take a fresh event to avoid prices going back into a more normal relationship. Thus, a probable scenario would be for the price of crude oil in the near contracts to decline to a more fundamentally stable price.

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