Where Is the Floor on Crude?

Having come just short of targeted $117 crude price goal with a $114.95 high print, is it time to follow short term swing momentum with the bears? It all depends on where the selling on crude will stop and longer term players deem crude a value buy again.

With the US dollar seeming to put in a floor on strong euro selling due to Greece announcing it is considering leaving the 17 nation European Currency bloc, US unemployment climbing to 9% and June oil futures down nearly 15% for the week, it might seem wise to run with the heard and get heavily shorted energy.

Despite the massive sell off this week, Fund managers remain net long on NYMEX crude futures and options. Whatever, the bottom may be on crude; analyst vary between $92 and $94, the one great fundamental supply issue remains with Libya. With worldwide global recovery continuing, demand for crude will continue to rise. Going into early next year, should Libya's crude remain out of the market, tighter supplies will keep the longer term crude bull market securely in place.

It is possible this year's high in crude has been achieved. However, should Libya's supply remain off the market crude prices will easily surpass this year's current high.

Egyptian/Israeli 1979 Peace Treaty in Jeapordy

The Camp David Accords of 1978 with Israel and Egypt resulted in the signing of the the first ever peace treaty by Israel with another Arab nation. The reason for not having any treaties before this time, despite thirty years of turmoil between Israel and its Arab neighbors, is simple. Arab nations hate Israel and refused to even talk to Israel. It was not until Egyptian President Anwar Sadat was smart enough to look past the hatred and focus on the economic well being of the Middle East, that a peace treaty was finally negotiated and signed on March 26, 1979.

Israel made the far greater sacrifice in giving up the Sinai peninsula where Israel was producing oil from the Sinai oil fields. Especially when factoring in today's price for oil. Prime Minister Menachem Begin was criticized severely even by conservative Israeli's for making this and other concessions to secure peace on Israeli's southern border. Prime Minister Begin understood correctly that not having to worry about having to defend its southern border was well worth the cost of the Israeli Sinai concessions.

Egyptian President Anwar Sadat was considered by other Arab countries, and even some in his own country, as a trader for signing the treaty with Israel and was eventually assassinated two years after signing. Upon Sadat's death all Arab countries voted against honoring the treaty. To its credit, Egypt has stood by the peace treaty.

With the recent overthrow of Egyptian President Hosni Mubarak the world is cheering the rise of a democratic style of government in Egypt. The great concern for future stability in the Middle East will be how does the new Egyptian government view the 1979 peace treaty? If the commitments of the treaty are no longer honored by Egypt, look for many years of instability and rising tensions in the Middle East, with the price of crude rising higher with the inevitable turmoil.

Geopolitical Risk Premium Supporting Energy Futures

The advance in crude futures slowed a bit this week, but the positively sloping trend is clearly intact. Even Portugal's well publicized financial difficulties failed to trigger a sell off in crude or the euro. Energy markets continue to remain fearful of the potential supply disruptions in the Middle East and possibly even Nigeria pricing in a premium on these global risks.

We now have crude poised above $105. A figure it has not seen since 2008. A pull back below $100 is quite possible. However, strong support will come in at $97, should swing traders be fortunate enough to see this number enter their variable algorithmic formulas.

The high probability trade will be to add to long positions on any pull backs and be prepared to ride the volatility to a $117 take profit target.

Backwardated Crude Term Structures Evidence Continued Positivley Sloped Futures Trend

Japan's increased energy import needs along with turmoil in Libya, Bahrain, Saudi Arabia, and Yemen, will continue to support higher crude prices. Crude and products pulled back slightly this week on temporary demand destruction from Japan. The reality is that Japan will have to find ways to make up for the 10% of nuclear energy production destroyed by recent events.

Evidence of continued crude pricing strength can be seen in the term structure of Brent crude futures becoming completely backwardated. Even well supplied WTI crude futures have turned backwardated from December 2011 onward. Stronger evidence on higher crude prices are evident on year spreads for WTI and Brent. One month ago the spread was at a $3.51 contango. On Friday this spread has gone to a $1.95 backwardation.

Backwardated pricing will continue to bring crude out of storage and into the market on stronger demand. When near months on WTI futures follow Brent trend, pricing will become even more supported.

If this was not bad enough news for anyone seeking lower crude and refined product prices, Nigeria is scheduled to hold elections in April. The trend on these elections is for rebel troops to destroy pipelines, squeezing supply of valuable light sweet crude and adding additional upward pricing pressure.

Middle East Uprisings Highlight the Importance of Supply Margin

Crude and its refined products, like any commodity, are ultimately priced on supply and demand. Sounds simple enough. The one complication added to these pricing inputs; expectation of future supply and demand. The sharp run up in crude prices the past few weeks shows how big a role expected supply and demand plays. The one buffer that will temper or exasperate expectations is spare production capacity.

No one really knows for sure how the problems in North Africa and Middle Eastern countries will resolve. We could experience a swift and peaceful change of these governments to stable democracies, continued prolonged unrest, or a combination of the two. What is known is the world is consuming 88 million bbls per day, up 2.7 million bbls per day from last year and expected to grow an additional 1.7 million bbls per day this year. At current crude production rates there are 4 to 5 millions bbls per day of spare capacity.

Even without turmoil in the Arab countries, the rising world demand for crude will cut into spare production margin bringing it down to 3 million bbls per day. Factor in potential production disruptions and the world could easily find itself with fuel supply shortages.

The narrowing of marginal crude production capacity is what is driving crude to multi year highs. Until more crude production capacity is added, or world economies collapse under the weight of higher crude prices, expectations will remain for supply not being able to outpace demand.

Will the Chicago Markets Follow the Deutsche Borse NYSE Lead?

The transformation of global capital markets ramped up quickly this week with the disclosure of Deutsche Borse in talks to acquire NYSE Euronext. Should the proposed merger be approved, the combined entity will dominate derivatives trading in Europe and America and has the potential of dominating stock trading. Germany will become the epicenter of global capital markets.

The driving forces behind the merger are economies of scale and market share. Trading system costs and regulatory expenses will be reduced in direct relation to scale of trading volume. The combined Deutsche Borse/NYSE will be an unassailable global market share growth monster dominating both continents. Costs will be reduced and pricing power will increase as competition evaporates.

How are the Chicago exchanges along with Nasdaq going to compete against this new dominant force? Joining forces and fighting to keep and expand market share appears to be the best solution.

The Chicago Mercantile Exchange already dominates US futures trading. Increased trading volume will have to come from growth in Europe. Nasdaq has an exchange in Sweden, but will find it very difficult to grow in Europe with a combined Deutsche Borse/NYSE.

The Chicago Board of Exchange, CBOE, is the largest US options mart, with several extremely valuable, exclusively traded large volume options. Because of its US options dominance, the CBOE is a very likely, though very expensive, take over target.

A combined Nasdaq, CME, CBOE, with perhaps an Asian exchange added, would make a formidable competitor to a united Deutsche Borse/ NYSE.

Deal makers will probably wait to see if the proposed Deutsch Borse/ NYSE merger becomes reality. If and when it does, additional exchange market merger announcements will be forth coming.

10% Probability of $4.00 Retail Gas In 2011

During an economic recovery, future demand expectations trumps current supply data bidding up futures for crude and refined products. This is why the energy complex has been on a relentless upward trend for the past two years. Seasonal refinery output factors that normally temper price movements have had little effect this year. Why is this happening?

The simple answer is that speculators have gone all in on long positions, taking profits at resistance levels and then repositioning long trades at support levels. This has prevented any sustainable sell off. It has also positioned term structures to move from a well supplied backwardation market to a high demand contango market.

The EIA released gas supply data last week showing gas supplies have been steadily increasing. Despite the ample supply, they are giving a 10% probability that retail gas prices will hit $4.00 per gallon, with a 50% chance of gas prices hitting $3.50 per gallon in 2011.

One hope for consumers is that everyone is leaning heavily to one side of the ship. Should a major demand or several demand reducing events occur in 2011, there will be a lot of traders trying to exit through a small door at the same time. Such an event would be China overshooting on its attempts to dampen its inflation. Another listing of the ship event would be the failure of several Eurozone banks.

Since neither of these events are highly likely to occur, traders will not try to rock the boat and continue positioning for the likelihood of a continued bull market.