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Oil Market update

Clive Maund
January 2nd, 2007

The outlook for the oil sector has deteriorated significantly since the last update. Oil itself has failed to break out of the potential intermediate base as expected, and although this may yet happen, the time it has now taken suggests that it would likely result in oil rising up to the $70 area to complete the Right Shoulder of a Head-and-Shoulders top area. Oil stocks did rally further towards the upper return line on the index charts, as expected, but the rally did not get far before reversal set in and the intermediate uptrend in force since early October failed. The growing weakness in commodities generally also provides an unfavorable backdrop.

On the 1-year chart for Light Crude we can see how it remains bogged down in a trading range, bounded by strong resistance in the $64.40 area, and support in the $56.40 - $58 area. It has been in this range since mid-September, so it is an important formation, a breakout from which, especially to the downside, will be a significant event in this market. The length of time that it has spent in this range means that the time window for a normal resumption of the uptrend is closing, and, with support being steadily eroded, downside risk is growing. One scenario that is a growing possibility is that the price does indeed break out upside from the range, but that it only goes on to rally to the $70 area, trapping new buyers in the Right Shoulder of a Head-and-Shoulders top, the Left Shoulder being the peak that formed from August through October 2005, visible on the longer-term chart below.

On the 6-year chart we can see the potential Head-and-Shoulders top, and how a rally to the $70 area would, if it was followed by reversal, complete this potential top area. Note that it would remain potential until it breaks down below its “neckline” as these patterns sometimes abort. On this chart it is further clear that we are now at an important juncture, with the price testing support at the long-term uptrend support line that dates back to the start of the bull market in oil late in 2001. A breakdown from this uptrend, especially if followed by a break below the support at the late 2005 low, signaled by a break below $54, would mean that the bull market is over.

Turning now to oil stocks, we can see how, on the 1-year OIX oil index chart, oil stocks failed to make it to the top line of the longer-term trend channel before the intermediate uptrend in force from early October failed, in the process completing a bearish Rising Wedge, implying further weakness ahead. The failure to reach the upper return line was a sign of overall weakening of the uptrend, and is frequently the harbinger of a significant breakdown ahead. In the event that oil breaks above $64.40 and makes a run at the $70 area, oil stocks would of course be expected to rally, and should this happen we would likely see this index advance towards the underside of the intermediate uptrend that it recently broke down from, i.e. to the 680 area. Oil should be keenly watched if this scenario comes to pass, for should it fail to get above $70, oil stocks can be unloaded at close to top dollar, and it may be wise to thin positions as oil approaches $70.

On the 6-year OIX oil index chart, we can see that, while still too early to call a top, the uptrend has been slowing and continues to slow. The important support at the September-October lows coincides at this time with the support of the long-term uptrend line, so we would expect the index to at least stage a bounce on a retreat to this level, even if it goes on break down from the long-term uptrend. An important background factor that should not be overlooked is the increasingly overbought condition of the broad stockmarket, a reversal in which would be expected to adversely impact this sector, which tends to move with the broad market much more than the mining sector.


Clive Maund
Jan 2, 2007

Clive Maund is an English technical analyst, holding a diploma from the Society of Technical Analysts, Cambridge and lives in Copiapo, Chile.

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No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.

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