I have warned in recent weeks that a tipping point for the oil price bubble and associated stocks was imminent and when I saw the cover of last week's Economist (one of my favourite contrary indicators) I increased my short bet. We're down 9.8% from the intraday high of just over $135 reached on May 21st, and the parabolic chart looks vulnerable to a deeper correction. The average decline among the 45 corrections in WTI crude since 1998 is 17% over a typical period of just under a month which would take us to $110. The deepest correction seen was 33.6% which would take us back to $88, which is probably near enough to fundamental fair value based on the marginal production cost of the most expensive new conventional oil and alternatives like tar sands of $70-80. On the weekly chart below, oil remains hugely in overbought territory and is still trading at nearly 3 standard deviations above its long term average in real terms.
However, event risk in energy is always to the upside, so I'd keep my trailing stop limits tight on any short position. The upside event risk over the next few months would most likely come from a Category 5 hurricane hitting the Texas Panhandle and damaging refineries/rigs or undersea pipelines, or an Israeli attack on Iran, the odds on which are now probably getting close to evens by year end. Note the uncompromising warning to Iran from the Israeli PM just yesterday, and the hardening of US rhetoric across the political spectrum. Don't forget that the Israeli Air Force destroyed a Syrian reactor last year to very muted international response, emboldening the hawks like Ehud Barak, the defence minister. Both PM Olmert in Israel and President Ahmadinejad in Iran are under intense domestic political pressure, Olmert for corruption and Ahmadinejad for economic incompetence, and this raises the stakes considerably. Personally, I suspect that if Israel has been given tacit approval by the Bush administration, any attack would come in the latter stages of the US election and therefore heavily influence the outcome (and that $200 oil spike forecast). Maybe Goldman Sachs have a mole in Tel Aviv...in the meantime, on fundamentals incremental supply is now outrunning demand, the dollar is steadily firming, and the Senate is elbowing the CFTC aside to conduct a witch hunt against speculators.
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