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Doubt over the EU Stress Test Results Prevents Oil from Catalyzing a Break Above $80

Doubt over the EU Stress Test Results Prevents Oil from Catalyzing a Break Above $80

2010-07-24 00:39:00
John Kicklighter, Chief Currency Strategist
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North American Commodity Update

Commodities - Energy

Doubt over the EU Stress Test Results Prevents Oil from Catalyzing a Break Above 80%

Crude Oil (LS NYMEX) - $78.98 // -$0.32 // -0.40%

There was significant event risk through the end of the week that could have sparked significant volatility for the energy markets. However, the collective macro economic data and vague EU stress test that defined the session would ultimately prevent crude from establishing a clear direction or meaningful volatility. In fact, just a day after the active US crude futures contract advanced to its highest close in 11 weeks (and rising above the 100-day moving average in the process), bulls would immediately yield to the $80 to $79.50 area that has stood as both support and resistance over the past five months. The technical hurdle was just an additional element to the market’s curbed advance. The true weight on the market was the fundamental backdrop that prevented market participants from building or unwinding a larger position.

There is little doubt that the modest activity for the day was the product of uncertainty surrounding the official review of the financial markets in Europe. The Stress Test has been touted and speculated on for weeks now; and the analysis that has gone into the region and the validity of the assessment has itself led to considerable volatility in risk-prone markets. On the day of the release for such a remarkable event, few traders will attempt to front run the release knowing the outcome could push the market quickly in the opposite direction of their position. The temporary stability that this establishes for the market can only be broken by a clear conclusion from the announcement. A test that is ineffectual or disappointing could lead to an unwinding of risky positions. Alternatively, an assurance of stability could encourage sidelined investors. However, the outcome for this event has yet to be decided. The market will make the assessment and the lack of liquidity in the final hours of the trading week would preclude a meaningful decision until Monday. What will the decision be? It is not yet clear; but there are enough holes to sink it.

Ultimately, the stability of the European financial market could have implications beyond the risk of holding a crude oil position; it could also alter growth forecasts and thereby the supply and demand dynamic. This development will occur over some time though. In the meantime, data released Friday has added a little validation to the market’s proximity to $80. Top event risk was the United Kingdom’s first reading of 2Q GDP. One of the largest oil consumers in the world, the UK has also lagged in its recovery. The 1.1 percent expansion through the three-month period matches the biggest increase seen in nine years. If the US can put up similar numbers next Friday with its own growth reading, a considerable weight will be lifted from the dull outlook.

For futures traders, today’s statistics were interesting. The volume on the active Nymex WTI crude contract (September) slipped to its lowest level for the week: 244,530. Further confirmation of a stay on activity was the drop in the CBOE’s Crude Oil Volatility Index which dropped settled at 32.4 percent near its lowest level in months. Also, the Commitment of Traders numbers from the CFCT reported a modest 4 percent drop in net long speculative positions in the week ending July 20th to a 36,145 contracts.

Crude Futures Chart (Daily)

2010-07-23-Commodity_Report_body_mzc4yt4t.png, Doubt over the EU Stress Test Results Prevents Oil from Catalyzing a Break Above $80

Chart generated usingFXCM Strategy Trader

Commodities - Metals

A Lack of Liquidity Keeps Gold from Responding to the Stress Test Results

Spot Gold - $1,189.20 // -$5.75 // -0.48%

While it may not be surprising to see gold hold steady while the rest of the capital markets anchored themselves through today’s heavy event risk; it is nonetheless a fundamental anomaly. The precious metal plays its part as a safe haven commodity; but it correlation to risk appetite is not perfect. Rather than representing a liquid asset that one can invest in just as long as equities are going down (and selling when they recover), gold is considered a long-term alternative investment that can weather financial instability, a renewed economic slump and seemingly inescapable exchange rate volatility. When we take this under consideration, it is somewhat difficult to believe that there was not a more meaningful development. In fact, the precious metal would not break from the congestion that has precluded a distinct trend for the entire week. It should be noted though that this period of drifting is occurring just above the technical floor of the market’s long-term climb. Should the need for such an expensive safe haven further diminish, this commodity could fall into a fundamental dive that quickly turns speculative.

At the beginning of next week, the market will return to the European stress test results and break them down for accuracy and value. Problems quickly arise when we consider that the three scenarios that were established for the testing would not include a sovereign default and capped the financial market’s troubles over the coming two years. This seems unrealistic at best. In reality, the group’s assessment of the 91 banks’ health matters little should a particular event further close the capital markets to these institutions or losses on sovereign debt holdings leverage default risk and a collective decline in the market. What’s more, the threat to Europe and the rest of the world is not isolated to these specific banks. Seemingly overlooked today was the news that ratings agency Standard & Poor’s warned Hungary could be downgraded because of the loss of its lifeline from the EU and IMF. Even further off the grid is the growing trouble in China. According to Bloomberg News, Chinese banks may struggle to recoup approximately 23 percent of the 7.7 trillion yuan worth of loans made to regional government vehicles used to fund infrastructure projects. Given the regulations that the government has put on further lending and the demand for an assessment by the end of the year, the economy could be looking at a credit and market crisis.

Looking at trading activity through the futures market, volume on the active futures contract was little changed from its monthly average today and open interest is diving ahead of the July contract’s expiration on the 28th of the month. That being said, Aggregate open interest across all the futures contracts has dropped to its lowest level since June 2nd. Seen a different way through the COT net speculative long interest report, investor interest dropped 13 percent this past week to 178,307 contracts (the lowest level since April 2nd).

Spot Silver - $18.11 // $0.01 // 0.03%

In contrast to Thursday’s aggressive rally (the biggest in six weeks), silver would move little into the end of the week. Without a proxy through demand for or divestment from gold, or a clear bearing on risk appetite trends; the metal would be left with little fundamental drive. It is worth noting though that speculators cut their net long positions by 10 percent through July 20th to 31,634 contracts.

Spot Gold Chart (Daily)

2010-07-23-Commodity_Report_body_0yir2dsa.png, Doubt over the EU Stress Test Results Prevents Oil from Catalyzing a Break Above $80

Chart generated usingFXCM Strategy Trader

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Written by John Kicklighter, Strategist

To receive John’s reports via email or to send Questions or Comments about an article; email jkicklighter@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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