The energy markets became riled over the weekend as Saudi Arabia took a major hit to oil production/distribution capabilities from drone attacks. Fingers are pointing at Iran and they have deferred to Yemen. The big issue here is whether this is the beginning of regular attacks and the disruption of oil flowing onto the markets or was it an isolated event?
Saudi Arabia will certainly get supplies back online, but the timing may be sooner or later. That will only be a small factor in the equation unless a large percentage of operations are offline for an extended period. In my mind, the biggest concern is the level of risk premium that should be in the oil markets. The supply and demand situation will probably work itself out in short order, but escalating assaults in the Middle East could propel the oil markets much higher. Figuring out this risk may be the key to a proper valuation for oil.
A Quick Look at the Supply Situation for Oil
The quick answer is that there is plenty of oil out there. The world is well supplied and prices settled into the sweet spot of $50 – $60 a barrel. The consumer is fairly happy at this level and the price is high enough to keep oil production moving forward. The relative absence of sabre rattling and supply disruptions has dwindled the risk premium that is usually bloated in oil prices. The declining economic activity in China and other parts of the globe has lowered expectations for demand as well. Oil prices could easily stay in this range or drift a little lower in my opinion based on the fundamentals. That was until the drones struck!
Game Changer for Oil Prices?
Saudi Arabia is only slightly behind the US in oil production and they largely supply China and India. Oil is their livelihood and they have taken great steps to secure their oil infrastructure. However, someone found a vulnerability in their security over the weekend and that is leaving a great deal of unanswered questions. If this can be repeated with relative ease, Saudi Arabian oil could be drastically reduced from the world market. That is the unknown that will keep traders on edge for a while.
Maybe an even bigger issue is whether Saudi Arabia will retaliate. I would have to believe they won’t let this attack go unanswered. That could be good or bad. Maybe they can eliminate the threat, but the risk remains for escalating tensions in the Middle East with a bullseye on Saudi Arabia. It is not exactly good timing either, as Saudi Aramaco is planning a release of its IPO. It would be the largest IPO ever, but it has been delayed time and again. I doubt they will release the IPO until this issue is resolved.
These types of events are typically isolated and cause a spike in the price of oil. Traders get worried and they exit short positions and many traders will chase the market higher. Prices tend to settle down in a few days as most people realize the world isn’t ending. It remains to be seen if this event will fall into that camp. The risk is higher to holding a short position, but maybe not as much after the spike higher on Monday. However, I would expect the market to get a bid on Friday afternoons into the close for a while.
Trading Crude Oil
My gut tells me the action on Monday was an over-reaction in oil prices. However, I would feel much better in that assessment if the price of oil was in the 80s. I am concerned about how this situation will play out in the next couple months. Tensions could easily escalate. That is nothing new for the Middle East, but I see the odds favoring less disruption. I believe Saudi Arabia will find a solution to the drone attacks, especially with having access to the US defense contractors. They are probably fairly well secured from the other more obvious sabotage attacks. Therefore, I believe this will be a relatively short-lived issue.
Furthermore, I don’t believe Iran has that many friends in the Middle East other than the obvious nefarious players. I would see Saudi Arabia operating from a position of strength and they will probably launch one major retaliatory strike that basically ends the conflict. Anything is possible, but that is how I see it playing out.
As for trading, it makes sense to me to trade from a shorter duration. The volatility was high on Monday and that means traders can dial down to shorter timeframes for trading. A five minute chart could now be traded on a one minute time frame. That can often help reduce the risk of taking signals from a higher timeframe.
I highly recommend making sure stops are always used. News stories can break at any time under these conditions and markets could react violently. This certainly applies to holding positions overnight as well. The weekend are the major risk. I would recommend at least hedging positions for anyone holding over the weekends for a while.
The oil market is offering some good trading opportunities at this point, but caution needs to be exercised in these conditions. There are many good trading strategies to take advantage of the volatility by trading intraday. I would also suggest using some type of spread or hedged position if you are holding position overnight or weekends.
Overall, it is a wildcard what this market will do. I would err on the side of things calming down and not chasing the market higher. There is a great risk if attacks continue on Saudi Arabia though. That would rattle the markets even further. Trading short term makes sense to me to take advantage of the volatility. Feel free to contact me at 630-485-2100, ext 532 or contact@futuresbuzz.com to discuss what types of trading strategies to use or crude oil.
