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Oversupply will dictate crude's price far more than sentiment

<strong>L</strong>AST week, oil prices touched the $60-a-barrel mark, almost double the low of $32 that they were in February. A reason to be cheerful? The International Energy Agency (IEA) clearly thought so last Tuesday, when its&nbsp;executive director Nobuo Tanaka indicated that the IEA was unlikely to reduce its demand forecast for 2009. But that opinion quickly changed, and on Thursday it announced that global oil consumption would fall this year at the fastest rate since 1981.&nbsp;<br />&nbsp;The downgrade might seem gloomy, but it was a sign that the IEA was facing reality. What drove the prices up over the past few months was hope, not supply and demand fundamentals. For contracts for difference (CFDs) traders, the lessons are clear: don&rsquo;t let optimism govern your trading, and be wary of betting on a further rally in crude oil in the near future.&nbsp;<br />&nbsp;The reasons that oil will fall are plain. Simple economics indicates that low levels of demand combined with oversupply will eventually put downward pressure on prices. As the recovery rally starts to fizzle, these fundamentals will become more apparent and more influential.&nbsp;<br />&nbsp;Why? Firstly, the rally has failed to increase demand. Opec, the IEA and the US government&rsquo;s Energy Information Administration have all recently lowered their forecasts. Weak demand has encouraged stockpiling of oil products on land and at sea: US oil inventories currently stand at 19-year highs and analysts estimate that well over 100m barrels of crude and refined oil are stored in super-tankers.&nbsp;<br />&nbsp;Secondly, some Opec countries are ignoring their quotas and overproducing. Last month the cartel raised its production target by 270,000 barrels after seven months of consecutive cuts, but higher oil prices have encouraged overproduction.&nbsp;<br /><strong>GREENBACK WEAKNESS</strong>Thirdly, because oil is priced in US dollars, the relative weakness of the greenback has boosted demand for crude oil and increased the price beyond the amount that supply and demand would suggest. Any rally in the dollar should be seen as negative for crude oil, but any further retreat in the dollar could see oil prices break through the $60 barrier.&nbsp;<br />&nbsp;Some analysts, including Ronnie Chopra at stockbroker Falcon Securities, think the upper end of the current range is toppy, and that it is worth CFD traders shorting oil around the $60 a barrel level.<br />&nbsp;Ashraf Laidi from CMC Markets, agrees, saying that downward market momentum is particularly expected to weigh on oil, saying that &ldquo;a looming rebound in the gold/oil ratio&rdquo; means that oil prices will underperform metals. He says oil technicals suggest an initial target of $54 by early this week, followed by $51.80, with a rebound limited at $57.80.<br /><strong>RECOVERY POTENTIAL</strong>CFD traders looking at individual oil companies have plenty of choice. You might look at BG Group, which has a high price/earnings ratio and with the price above 1,100p is worth a short to 1,050p although the company&rsquo;s long-term prospects are good. Another potential short is Cairn Energy, seemingly overvalued at current levels of 2,350p, especially if the oil price slips. For quality and recovery potential as well as the attractive dividend yield, BP is worth going long below 480p, while Royal Dutch also is attractive for income-seekers due to the high dividend yield &ndash; the recent rise to 1,600p has made the share price seem a little high so it would only be worth going long around 1,550p.&nbsp;<br />&nbsp;CFD traders should also look to benefit from pairs trading in the oil companies by going short on the company that appears overvalued and long on the undervalued one. In an earnings season individual stocks can get temporarily derailed from the longer-term sectoral trend. Now would be a good time to look for such opportunities.&nbsp;<br />&nbsp;The recent oil price rise has been based on optimism rather than reality. Opec has finally started realising that it can&rsquo;t wish a recovery into existence. Traders should do the same.&nbsp;