Recent sell-off reason to buy oil, not short it

AFTER a week where the price of crude oil futures slid to below $70 a barrel and oil giants disappointed the markets with poor earnings and weak outlooks, contracts for difference (CFDs) traders might be finding it difficult to justify going long on crude right now. The markets are still cautious – sovereign debt crises abound in Europe and there are ongoing concerns about macroeconomic and geopolitical stability.

Last week, there was also speculation among traders that Thursday’s 5 per cent sell-off – the biggest daily percentage fall since July – was caused by commodities hedge fund BlueGold Capital Management liquidating positions – an assertion quickly denied by the firm, which added that the oil outlook for 2010 was bullish.

Francisco Blanch, head of global commodities research at Bank of America-Merrill Lynch, says that after four months of trading between $70 and $85 per barrel, the crude oil market could be reaching an inflection point, which suggests an important shift ahead. Last week might have been pretty dismal for crude oil, but there are two good reasons to be positive at the moment about how the black gold will fare in 2010.

First, supply fundamentals are starting to look stronger. After a long period of excess inventories, US weekly data shows that the overhang (where stocks exceed demand) of US crude and product inventories has fallen to its lowest level since the start of 2009. Blanch says: “From a fundamental perspective, crude oil inventories are no longer high enough for limited storage capacity to be a concern to the market and we expect a continued cyclical demand recovery in the months ahead.”

He adds: “In our opinion, inventories are currently in a robust, albeit gradual, trend towards more normal levels. Given the spare storage capacity to accommodate negative demand shocks, we believe the risk of a sudden price collapse has diminished significantly.” This will limit the downside risk for CFD traders bullish on oil. The more robust inventories should also limit the chance of prices spiking higher.

Secondly, more upbeat economic data means that negativity about supply has receded. The macro environment still presents a risk for the crude oil price – measures of future volatility for crude are still at relatively high levels – but Bank of America-Merrill Lynch forecasts that this should subside and that the West Texas Intermediate price should be supported above $70 a barrel and trading towards an average of $92 in the second half of this year.

Rather than being the beginning of sustained weakness in crude oil, the current price of around $69 is the perfect point at which to pick up long positions.