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Oil prices hit the top of their triangle

Oil markets
By Paul Hodges on 25-Feb-2012

Brent Feb12.pngOil prices are poised at a critical point. As the chart shows, the recent rally has taken them to the top of the triangle formation that has built up over the past decade. Players now need to decide if they are confident enough to push prices into higher ground.

A lot of different reasons have been advanced for the rise. But most of them are ‘stories’ rather than reality. They may fool pension funds, but not serious traders:

• There is no major surge in demand, as in 2008
• Inventories are also at reasonable levels
• Saudi is pumping 10mbd and has promised to keep the market supplied
• In euro terms, oil prices are at record levels and EU demand is falling
• The US is a net exporter of oil products for the first time in 60 years
• China’s demand is slowing, with retail prices 36% above 2008 levels

The real reason, as the Wall Street Journal noted yesterday, is the liquidity provided by the Federal Reserve to the high-frequency traders.

However, the Iran issue is separate from this and represents a real threat. If the Strait of Hormuz was blocked, then oil exports would suffer, and shortages could easily appear.

Prices could then jump higher, perhaps to $150/bbl, as suggested by Vitol CEO Ian Taylor this week. But Taylor said this was not their base case, noting that the idea of prices going above the record $147/bbl was “unlikely, but it is possible”.

We have, of course, also been in today’s situation before, in the summer of 2008. Then the blog famously suggested, against all conventional opinion, that prices “could easily fall $50/bbl to $100/bbl” if diplomacy worked. And fall they did.

The blog would not therefore rush to ‘go long’ at today’s high prices:

• It is over 2 months since Iran first made the threat
• Governments and major companies have all prepared contingency plans
• Today’s price levels are already causing demand destruction

Equally, from a purely commercial viewpoint, the blog suspects Iran may have to cut prices to achieve sales. China, Japan and India have every incentive to exploit their position as the only major markets left open to Iran. And as oil importers, they have no downside from doing this.

The only prudent course, as the outcome is essentially unknowable, is to hedge both possible outcomes:

• Most companies will by now have put hedges in place against higher prices, as part of their contingency plans. If oil now heads higher out of the triangle, then they have covered this risk.
• If prices fail to break higher, then their next step might instead be to use today’s higher prices as a platform for opening new hedges to guard against the downside risk