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The temptations of oil...why aren’t we buyers?

17 April 2008

The Technical Trader’s view:

The technicals look strong for oil but we think there are compelling macro arguments that cancel out the charts suggesting a continued neutral stance.

The big picture for oil is clear enough.

The push up through the $40 level signalled the beginning of the great bull run.

The push up through the interim high at $78.40 was the signal for the market to higher still.

The market has ratcheted better – most notably off the $97.88 level, in textbook style.

Note the way the $98.52 level has been twice tested.

It held, and in so doing, a Continuation Triangle was created that has driven the market higher still...minimum target 117.40.

Through the recent Pivotal High of $109.02

Which should act as good support on any pull-back.

So the market looks well set.

Why aren’t we buyers?

The Macro Trader’s view:

Over recent weeks we have maintained our neutral stance in oil as we judged:
- the recession gripping the US economy,
- the slowdown clearly threatening the UK economy, and
- the likelihood that the other major economies; the Euro zone, China and India, too would suffer a reduction in growth, resulting in lower demand for energy,

Which meant we thought the next major move in the oil market was likely to be down.

So why has oil continued to rally?

Part of the explanation offered by many analysts is linked to inflation and the weak Dollar. While it is true that commodities have tended to enjoy bull markets during past periods of inflation, this time around oil is the chief reason for the current bout of global inflation, which has its roots firmly imbedded in the Iraq war and subsequent chaos.

Another reason put forward is the involvement of hedge funds in the commodity markets, seeking greater exposure to an asset class that offers diversification from equities and other financial assets.

Our opinion is that we are in the end-game of a well-established and long-lived rally. Typically, as a rally such as this matures, less sophisticated investors join in wanting to profit from what looks like a “one way” bet. This tends to prolong a rally that may already have passed its sell by date.

However, the fundamentals ultimately re-assert control and the market turns. The professional investor recognizes the shift in sentiment and gets out; others risk being caught out.

We judge now is not the right time to be long of this market; true it has made a new high this week, but what is driving the market?
- US inventories have come in lower than expected this week,
- Nigeria may see a decline in its output over the coming years, and
- Russia may have passed its production peak.

Russia only needs to stop harassing western oil companies and work with them and its ability to pump oil will be greatly enhanced, and Nigeria’s mooted decline is in the future and by no means certain.

And offsetting this is the news out this week that a massive oil field has been discovered off the coast of Rio de Janeiro, reported to contain some 33B barrels of oil.

In summary, we fail to see how the current oil market rally can endure much longer when the world’s largest consumer of energy; the US is in a recession which analysts and policy makers alike acknowledge could be the worst the US has experience since WW11. Moreover, with all the other major economies at risk and the IMF forecasting a global slowdown, there could soon be an excess of supply over demand.

So though it is tempting to join a market that seems to move higher almost relentlessly, we think it’s very dangerous. Remain sidelined and wait for the turn.

Mark Sturdy
John Lewis
Seven Days Ahead

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