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By Robert Rapier on Nov 12, 2007 with no responses

Prepare for Volatility

I saw a comment from someone yesterday that if this week’s inventory report shows a sharp drop in crude inventories, oil will probably spike up above $100. I do think that because of the storms in the North Sea and the flooding in Mexico we will see a decent inventory draw this week. But I don’t think the price will spike to $100 on the news, because this week is complicated by a number of factors.

The first is that the inventory report will be delayed by a day this week, due to the government holiday on Monday. The second is that the front-month WTI contract expires the day after the inventory report is released. There are a lot of people holding contracts that must be sold by Friday. What I expect then is that any bad news that pushes prices higher will be met by speculators selling into the rise.

Another factor that may cause tremendous volatility is that December options contracts expire on Tuesday. If crude doesn’t trade at or above $100, those options expire worthless. This means that there is a tremendous incentive for a lot of people to talk up the price today and tomorrow. I would expect a load of analysts over the next couple of days to appear on TV and “explain” why things are much worse than they seem.

Today’s Houston Chronicle has a story on the expected roller-coaster this week:

Wild week ahead for price of oil

Here is a quick summary, pulled from excerpts in the story:

It’s a situation one analyst likened to a high-stakes poker game. A showdown between traders who believe the price will rise and those who believe it will fall could bring both results — a brief taste of $100, followed by a rapid sell-off.

Lehman Brothers’ Morse said in the report that the Dec. 7 futures contract for West Texas Intermediate crude — the U.S. benchmark — will expire Friday, and 360,000 contracts remained outstanding. Most of those contracts are held by financial players in the oil market and must be sold by the expiration date, Morse said.

“Presumably, market participants know that the exits are going to be crowded over the next few days if they do not sell their positions soon,” he said.

Adding fuel is the West Texas Intermediate options market on the Nymex, where 42,000 Dec. 7 call options for $100 are set to expire Tuesday.

An option to buy at $100 a barrel will only be profitable if oil costs more than that sometime before the option expires. So those 42,000 call options will “expire worthless” on Tuesday if oil doesn’t reach $100 a barrel by then.

“Perhaps, before Tuesday, holders of these calls will attempt to push oil to $100 in a last effort to force these options into the money,” he said.

So there are 360,000 contracts, most of which must be sold between now and Friday. And there are 42,000 options that will only benefit if oil makes it to $100. The expectation is that the traders holding those 42,000 options will talk the price up. But they are going to face the headwind of those holders of those 360,000 contracts trying to liquidate by Friday. I just can’t see oil reaching $100 in the face of that.

Eric Wittenauer, an analyst with A.G. Edwards & Sons, said 42,000 call options at $100 indicated that the holders expect they will be able to exercise them at that price.

“I think it’s a logical argument that someone’s going to have a lot of money on the line and potentially want to drive the price up to $100 and above,” he said. “If you break through $100 and tack on some more, you make that much more profit on your positions.”

Morse said speculators could back off and take profits before a barrel hits $100, but the price most likely will make “a serious run at $100″ by Tuesday and perhaps reach $105 before selling pressure ensues.

It is certainly a credible argument that the holders of those options will try to talk up the price. But I don’t think it is at all credible that they can actually talk up the price to that level. It will take a major geopolitical event or natural disaster to affect prices that strongly. If we don’t see any major news by Tuesday’s close, and oil trades over $100, I will be stunned. As I write this, WTI is trading at $94.94. It’s not going to make it to $100 by tomorrow just on the basis of traders trying to talk it up.

I do agree that we could see a sharp sell-off by Friday:

Then, with the contracts that must be sold by Friday, the rush to sell “may be stronger than anything the oil market has seen in several years,” Morse said.

He said prices could fall to the low $80 range by early December.

I don’t think oil is going to fall to $80 in 3 weeks, but I have said again and again that I don’t think the current price is sustainable in the short term. I think we will pull back shortly, and make another run at $100 in 2008. However, if OPEC doesn’t say the right things following their meeting this week, they will toss more fuel on the fire and make it more unlikely that prices will have a huge correction.

Full Disclosure: I don’t hold any commodities positions. Although I am beginning to think that I should. :-)