Why Was Crude Up Huge On Monday?
Posted on: September 23, 2008 - Email Article - Printable Version
The trading at the New York Merchantile Exchange (NYMEX) on Monday turned from ordinary to absurd extremely quickly as oil had by far it’s largest one day nominal and percentage gain. I have now been covering the energy sector for more than two years but this was easily the most unbelievable trading day I have ever experienced. Crude oil opened the day at $104.55 and closed at $120.92 while hitting an intraday high of around $130.00. The trading became very volatile around 2:15pm that the NYMEX actually halted trading for about a minute because crude oil hit the one day stop out of a $10 gain. Within a few minutes the rules were changed and crude intraday appreciated more than $25 a barrel. The one day gain of $16.37 or 15.66% is the largest in the history of trading and is something I doubt we will ever seen again, nothing sort of a one in a million event. The real question though is why?
Futures Contracts
The primary reason for the run up in crude today (although not the only reason by any means) was a short squeeze that occurred on the front month futures contracts that were expiring today. These September contracts were the current futures heading into today but now the October contracts are the front month futures. Because these futures were set to expire today, many people decided to take nice two day gains from Thursday and Friday and unwind their positions so that they could roll over to futures contracts for upcoming months. This phenomenon is not unusual and occurs every time the front month futures are set to expire.
Short-Squeeze
The technical term for what occurred today is called a short squeeze. This refers to a specific situation when investors are driven out of their short positions in an investment because of margin calls related to upward price swings greater than previously anticipated by the short sellers. Once short sellers at the bottom are squeezed out, they will all attempt to dump their shares back into the market for a higher price driving the price of the asset even higher than it was before they received their margin calls. This new price appreciation causes a new set of short sellers to receive margin calls and this process continues until many of the short sellers are driven out of the market. As we saw around 2:15 PM EST today the move up was very quick and violent, and many of the shorts had no choice but to sell their shares back into a market with inflated prices.
Why Were Investors Short?
Because of a two day price gain of over $10.00 that took place at the end of last week, many investors believed it was a good time to short crude since the price had appreciated so rapidly. Their thesis was backed up by the fact that the United States Dollar had appreciated greatly over the last month. Crude oil is priced in U.S. Dollars so an appreciation in the dollar would lead to a decrease in crude oil prices. It is generally believed that in today’s market a 1% swing up or down in the dollar will cause a $3 swing respectively in the price of crude oil. Because the U.S. Dollar and crude oil had appreciated so quickly over the same period of time, many investors were betting that the crude rally was a false rally and that there would be easy money available for the shorts.
What Caused The Positions To Unwind?
Unfortunately for the shorts, they did not account for the Federal Reserves actions on Sunday when they made their bets at the end of last week. In fact, there was no way they could have accounted for the move to commercialize investment banks because it was an event unprecedented in the history of free market capitalism in this country. After investors determined how much more money the Federal Reserve was going to have to pump into the system, they realized that the U.S. Dollar was going to depreciate due to a large amount of new supply. This sharp move downward in the U.S. Dollar caused crude oil to move much higher.
Conclusion
Crude closed just over $9.00 off of the intraday high, but I would expect that this could be the beginning of the end for those that thought energy and commodity prices were a bubble that had just burst. I don’t think crude will go straight up from here but I do think that it is likely crude goes to $147 again before it goes back towards the lows we had established recently in the $90.00s. Regardless of futures contracts, short sellers, technical analysis, hedge funds, and anything else in between, the crude story over the long term is backed up by a fundamental shortage of supply. Crude pricing is impossible to predict in the near and even in the intermediate term, but over the long run prices will appreciate as energy consumption grows at a much faster rate than energy production.
- Charles W. Petredis
Disclosure: None
Comments
I think the $700 billion bailout had much to do with the price rise as well.
If such a plan passes, it signals inflation ahead as the printing presses will be rolling.
A debased dollar will equal higher crude prices.
I hinted at the bailout out and commercialization of GS and MS in the second to last paragraph. I agree with you completely as to that being the reason the dollar started to deteriorate and I think its likely you see the dollar fall a bit further before making a rebound when investors realize how bad of a situation is currently brewing over in Europe.
Charles W. Petrediss last blog post..Why Was Crude Up Huge On Monday?
A lot of people thought that the rally was dead, but the fact is that during recessionary periods commodities almost always overpower equities. We have guys like Rainwater & Pickens starting to speak highly of Simmons. (The same guy who predicted the oil rally some years back) Everyone thought he was crazy then… but is he really? In addition to the short squeeze, I have to agree with Chris that the significant bailout from the Fed, sent people to seek more safer holdings, amongst other things such as Gold. I remember reading an article from Goldman that they saw oil going to the $180-200s in the next year or two. Regardless of how slow or erratic the rally is, IMO its upward trending. I read a great post at stockresearchportalblog.com outlining methods to value mining companies, apparently it’s a 17 part series, and though I’ve only read the first 3 so far I’ve learned a ton.