DailyFX Research

By John Kicklighter, Currency Strategist, and Timothy Shea, Market Analyst Published: April 11, 2011

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Crude Oil Forecast: The Next Six Months Promises Volatility, but Not Direction

With much uncertainty on the horizon, the next six months promise significant volatility in oil prices. There are several important themes to watch in this market, which may or may not materialize, but are likely to leave the market jittery. This forecast will help you navigate the next 6 months in oil. It is difficult to forecast where oil prices will be six months from now because the market is currently wading through many unique fundamental events. Any one of many prominent catalysts could take the markets reins; and few of them currently have a clear bearing. That being said, when projecting the trading conditions for any market, direction is complemented by the level of activity. A clear direction with a low level of volatility makes for a quiet and difficult-to-trade market. What we are looking at in the next six months is instead shifting episodes of direction backed by a consistent swell in volatility. To gauge where oil is headed, it is important to follow the key developments that have stirred the capital markets over the past half year. Among the most influential drivers so far this year are the instability in the Middle East, the early spike in underlying risk appetite trends, and the steady rise in global growth. Let us look at each in turn.

ItsSimpleReally
Like every trade made, the outlook for oil can be distilled to its foundation a risk / reward balance. For this particular commodity, supply-and-demand is vital. Let us start with demand. Energy is needed when an economy (for our purposes, the global economy) is expanding. While there have been significant hurdles to strong economic expansion (including deficits, financial crises and inflation); the global economy has nonetheless shown a consistent trend of restrained expansion on the back of strong growth in large emerging economies, such as China, India, and Brazil. When it comes to demand, the entire world has some level of demand for oil. However, the health of the industrialized economies is a good gauge for future oil consumption. At the top of the list is the world's largest oil consumer, the United States. The US posted a 2.8 percent annualized rate of growth through the end of 2010. This brings the US economy close to the rate of growth seen before the financial crisis of 2008/2009. The Chinese economy grew by 9.8 percent while European Union level growth topped 2.0 percent. In fact, the OECD (The Organization for Economic Co-Operation and Development) projects that net growth for the advanced economies it tracks will run 2.3 percent. So, while we may have a cooling in pace for different regions; the overall health of the global economy should keep demand for oil elevated.

ASupplyShockAkintothe1970sEnergyCrisis?
Oil prices are as keenly sensitive to supply concerns. In the opening quarter of 2011, we have seen output fears reach levels not seen since the energy crises of the 1970s. Once again, the source of these supply concerns is the Middle East. Starting with a democratic uprising in Tunisia, unrest has spread to Egypt, Libya, Bahrain, and elsewhere. Many of these countries are notable contributors to global energy output; and disruptions in this supply chain will have a direct impact on oil prices. The greatest threat to supply would be for turmoil to spread to other OPEC members that produce significantly more oil. Bahrain is an important member of the Gulf Cooperation Council a Middle Eastern economic and political alliance amongst large petroleum producers that is currently facing democratic protests. Should unrest spread to other GCC members (such as Saudi Arabia), the expected disruption in
The information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified. Forex Capital Markets, L.L.C. assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any persons reliance upon this information. Forex Capital Markets, L.L.C. does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Forex Capital Markets, L.L.C. shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.

DailyFX Research
TheresMorethanJustSupplyandDemand

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output could cause prices to skyrocket. While there will likely be a concerted effort to quell any conflict, the global markets are very sensitive to threats to otherwise steady oil supply streams.

While we can condense fundamental analysis of the energy market to supply and demand; expectations and speculation can also have a prominent influence over price action. This is where the greatest potential for volatility lies. To see visually how sensitive oil prices are to changes in investor sentiment, take a look at the graph below. This shows the activity of oil prices (the purple line) against the performance of benchmark equity indexes from the US, Europe and Asia. The correlation is clear. The reasoning behind this relationship, however, may not be. Though commodities like oil are used for actual production and consumption; the market for these necessary goods can be accessed by speculators as well as consumers. As investors the world over seek higher returns and a diversified portfolio, many have made an effort to incorporate oil into their investments. Also, since stocks typically rise when economic activity is expanding, some investors will buy oil futures at the same time they are buying shares as they expect that economic growth will fuel both a rise in company revenues demand for oil. At the same time, when there is a concerted effort to sell risky positions in stocks and other asset classes, that selling tends to spill over to crude.

Data source: FXCM Strategy Trader and Bloomberg

The information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified. Forex Capital Markets, L.L.C. assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any persons reliance upon this information. Forex Capital Markets, L.L.C. does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Forex Capital Markets, L.L.C. shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.

DailyFX Research
LookingforTrouble

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The outlook for investor sentiment is far more difficult to pin down than the outlook for basic supply and demand led by economic growth. There is plenty of reason for uncertainty to persist including the ongoing rumblings of financial instability in European governments and the US housing market. The recovery in financial market stability and economic activity has so far been heavily influenced by government support and stimulus. Yet, this stimulus is inevitably temporary. Eventually, stimulus will be withdrawn; and investors will not have the implicit guarantees of safety. Adding to the complexity of the situation, market participants tend to get into or out of speculative positions well before any actual changes in activity. To get a good bearing on underlying risk appetite and its potential impact on energy prices, we should keep an eye on volatility. The CBOE VIX Index, which is based on volatility in the S&P 500 equities index, recently surged to its highest level in nearly nine months. Meanwhile, the Crude Oil Volatility Index, which reflects expectations for oil price volatility, hit similar highs. This tells us that the market is likely preparing for large price swings.

Data Source: Bloomberg

MoreSpecificThreatstoSpeculation
Currently, there are threats to general investor sentiment, as well as to oil prices in particular. These ongoing events can quickly change the direction of crude prices; and so we need to be especially attentive to them. The political unrest in the Middle East and North Africa is perhaps the biggest question mark because it directly effects expectations for oil supply. Other situations we should monitor include the effects of the earthquake in Japan, a rebalancing of investment capital away from emerging markets and the European
The information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified. Forex Capital Markets, L.L.C. assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any persons reliance upon this information. Forex Capital Markets, L.L.C. does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Forex Capital Markets, L.L.C. shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.

DailyFX Research

www.dailyfx.com www.fxcm.com 1.212.897.7600 1.888-50-FOREX

debt crisis. The most severe earthquake on record for Japan resulted in a tremendous loss of life, structural damage, power outages, lost productivity and spreading of radiation. This not only holds implications for energy demand from the world's third largest economy; but it also undermines confidence in the smooth operation of its capital markets. The same holds true for EU officials efforts to secure confidence in their financial markets. Should the European Unions position as a safe and benchmark investment area be cast into more serious doubt, the shock to energy markets (and hence, oil prices) could be severe. Finally, there is a concern that has not yet captured the markets full attention: the fear of capital controls, rate hikes and growth-killing inflation in emerging economies. This will eventually encourage investors to shift funds back to developed markets. This rebalancing will be seen as a reduction in risk taking that will no doubt curb speculation in risky oil markets.

ExposurethroughCorrelations
When we are looking to trade changes in oil prices; it is important to consider both our approach and our strategy. We need to keep in mind the correlations that oil prices have with the broader market. As we showed above, crude prices generally move in the same direction as equities over time, as both are tied to prospects for economic growth. This means that if we are both long stocks and long energy; then we are increasing our bets on a single theme: that growth and sentiment will improve. The concept of diversification rests not just in using different assets; but in further balancing positions so that if a common theme unexpectedly strikes the financial markets, there is not a loss amongst all the assets you hold. As such, a good means to offset some of the speculative risk we take with oil is to trade other assets like currency. For example, as we can see in the graph below, oil prices have a very strong negative correlation to the USD/CAD currency pair. This means that often times when oil is rising, USD/CAD is falling at a very similar pace. So, if we think that supply concerns will hold through the immediate future while demand remains consistent, we can look to buy USD/CAD in order to provide a reasonable counterbalance to your portfolio. Furthermore, the USD/CAD currency pair is traded 24 hours per day with tight bid/ask spreads. The fact that Canada also has higher interest rates than the United States also means that carry traders can earn interest daily on short positions in the USD/CAD (Conversely, you pay interest if long the pair). This can help traders holding an oil-bullish position, where oil futures contract rollover in a normal market can be expensive.

The information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified. Forex Capital Markets, L.L.C. assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any persons reliance upon this information. Forex Capital Markets, L.L.C. does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Forex Capital Markets, L.L.C. shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.

DailyFX Research

www.dailyfx.com www.fxcm.com 1.212.897.7600 1.888-50-FOREX

Data source: FXCM Strategy Trader and Bloomberg

The information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified. Forex Capital Markets, L.L.C. assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any persons reliance upon this information. Forex Capital Markets, L.L.C. does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. Forex Capital Markets, L.L.C. shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results.