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The Oil Price: Warning of War?

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When you’re just not sure what any of it means anymore, there’s always the price action. That’s the basic theory behind Murray’s trading method at Slipstream Trader. He takes his customary mid-week look at markets today with a video update. Click stock market update to watch it now.

One of the markets we meant to look at briefly yesterday was the oil market. It is preparing for war. But its preparations were disrupted yesterday by a trading “glitch”. Dow Jones newswires reports that, “Crude futures settled higher overnight in a chaotic trading session as a failure of CME Group’s Globex electronic oil-trading platform shut out scores of traders and forced all trading onto the New York Mercantile Exchange floor.”

That’s kind of strange. The interruption of electronic trading didn’t make much difference to the closing price for the March futures contract. It closed at just about US$100. But it would have been something to see all those traders run from their green screens and rush to the pit to make trades the old-fashioned way.

It’s amazing there hasn’t been a deliberate hack or attack on electronic markets yet, by the way. It will happen eventually. Either a whole index will be attacked, or maybe just a single share held to ransom. You might even argue that high frequency trading and algorithms are a kind of legal share price hacking.

In any event, let’s assume that prices are legitimate and look at one of them in particular, Brent Crude Oil. We wrote yesterday that the oil market is preparing for war. By that, we meant that the price of Brent crude has broken out of a channel where it was making lower highs and lower lows. Have a look at the chart below.

Oil building a war premium

Oil building a war premium

To be fair, our method of chart analysis is not nearly as thorough as Murray’s. But we’re looking at the chart to see how it squares with our macro-view. This chart is a bit of a riddle. You can see at least three different ideas embedded in it.

The first idea is that oil prices can crash. That may seem too obvious to point out. But how many people thought oil would fall from $140/barrel in mid-2008 to less than $40 by the end of the year? Not too many, your editor included. Today’s high oil prices should be viewed with 2008 in mind.

The second idea: oil may be a lousy inflation hedge. The investment industry has propagated the idea that exposure to oil is one way to hedge a falling US dollar. Since oil is priced in dollars this makes sense. When you have more dollars chasing oil, prices rise.

The chart suggests that oil prices may be the product of inflation more than a hedge against it. There’s certainly a fair bit of volatility in the oil price. If you wanted a hedge against inflation that would let you sleep well at night, oil wouldn’t be it.

The third idea we get from the chart is that the recovery since the crash-low of 2009 doesn’t have much conviction. You have some people buying oil as a dollar crash hedge. You have some people buying it on pure supply/demand dynamics. And you have some people buying it because they think there’s going to be a shooting war in the Middle East.

The very latest price action, in which the oil price breaks out of the little trend channel we’ve drawn over it, is the last thing we’d bring to your attention. Is this directly related to the possibility that Israel could attack Iran? Are traders building in the war premium to the oil price?

This is a tricky one. Various pundits have been warning of/advocating for an Israeli strike on Iran. Yet the more we think about it, the less likely we imagine this will ever happen. No one really wants it to happen. It’s disaster for all parties involved. Only the zealots and the ideologues believe it is inevitable.

You’d think that as long as the adults in the room were calling the shots, there won’t be a war with Iran. But the margin is just as important in geopolitics as it is in economics. A small group of dedicated people can “tip” the rest of the crowd into irrational behaviour. The result is a kind of economic and cultural suicide that ends a period of prosperity.

Could that happen now? It might be the natural evolution of the financial crisis into a political and military crisis. Maybe this is how complex systems decay and disintegrate. They have enough life in them to be dangerous, especially with individual human beings at the head of them.

The Western world has been so safe, comfortable, and prosperous for most people in the last 20 years that it’s almost unimaginable we could be seriously inconvenienced. It’s even more unimaginable that Great Powers like China, the US, and Europe would permit a war to break out smack dab in the middle of the world’s largest oil reserves. But collective plunges into insanity and war happen pretty regularly in human history.


Dan Denning
for The Daily Reckoning Australia

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