Oil Market Update
January 28th, 2008
Although commodities generally should do well as a result of rampant worldwide inflation, and in some cases hyperinflation, it is obvious that demand for oil is much more closely aligned with the broad economic cycle than, say, the demand for Precious Metals. Thus, while the demand for oil may contract in the event of widespread severe recession or even depression, the demand for Precious Metals would probably rise at the same time, due to the fear factor and in the situation we are soon to find ourselves in, the acute dearth of safe investment vehicles. The extent to which the demand for oil moderates will of course depend on how widespread the recession/depression is and whether countries like China and India get sucked into its vortex. It is actually quite clear that these countries won’t escape, a fact made painfully obvious by the recent severe declines in their stockmarkets, with the Chinese market now in position to crash, after the current “last gasp” relief rally has run its course. A marked dip in demand for oil can of course occur over a shorter time horizon, regardless of the acute longer-term shortages that are expected to result from an eventual resumption of growth and increased population etc.
We will now look at the charts, starting with the 6-month chart for Light Crude. The forecast made in last month’s update proved to be correct, when the following was written: “It seems likely that oil will react back at least to the lower support line of the intermediate uptrend channel, currently at about $82 and rising, although this does not mean that the price will react back to $82, as it could simply mark time in a trading range until the channel line catches up. The most probable scenario is that it will drift gently lower for a month or two. There has been startling volatility in oil in recent weeks with an unusual $4 up day occurring just a week ago. This sort of jumpiness is a symptom of an overexcited market with a higher percentage of speculative interest than normal, and is therefore interpreted as a bearish sign. Another possibility that we should take into account is that oil could retest last months highs in the near future and then turn lower again.” The possibility mentioned in the last sentence is exactly what occurred, and some traders may recall the hoopla when oil briefly poked its nose through the $100 a barrel level, generating the predictable media interest, only to turn tail and go into a determined downtrend. This is typical market behaviour. Looking at the chart we can see that the steep and steady downtrend through most of this month has brought oil back to an important support level at the bottom of a rectangular trading range, the lower boundary of which is delineated by the early December low. We now have several factors pointing to a strong rebound back towards the top of the trading range again, although it may not get that far. One has just been mentioned, which is that the steep downtrend has brought the price back to a strong support level. This has resulted in a quite deeply oversold condition, increasing the probability of a worthwhile trading bounce. Furthermore the decline has driven the price way below the 50-day moving average and towards the still strongly rising 200-day moving average, once again increases the odds of a rally, as the alignment of the latter average means that the downtrend this month must be classified as a countertrend move (even if the larger uptrend is in the early stages of failing). Finally, a bullish hammer candlestick appeared on the chart on Tuesday, indicating probable exhaustion of the downtrend.
On the 7-year chart for Light Crude we can see the continuing long-term uptrend in oil. Of note is that the advance last year did not reach the top return line of the uptrend channel, instead stopping at a trendline drawn across the 2005 and 2006 peaks. Oil will need to break above this line and run at the original return line to negate the potentially bearish implications of the current converging channel. Although it is way too early to turn bearish and viewed as most unwise to trade against the long-term uptrend, except at overbought extremes or when a confluence of factors points to a breakdown, this deterioration is something we should remain aware of.
Oil stocks are much more vulnerable to the vagaries of the stockmarket, of course, than oil itself is, as is obvious when the 6-month charts for oil and oil stocks are compared. On the OIX oil stock index chart we can see how, after making new highs at the start of the year, oil stocks plunged dramatically this month to become really deeply oversold a couple of days ago. We had taken note of a bearish broadening pattern in the December update, and had anticipated a possible reaction back to the vicinity of the 200-day moving average, but the panic in world stockmarkets drove it even lower, breaking it down from the bearish Broadening Top pattern. This was a development that carries longer-term bearish implications, notwithstanding a probable strong rally back into the broadening pattern short-term, and thus we can expect oil stocks to roll over again later and drop steeply in sympathy with the broad market, once the developing rally has run its course. How far is the nascent rally likely to get? It is likely to run in parallel with the broad market relief rally and to end when it does, and a reasonable target for it would be the vicinity of the 50-day moving average, or about 820 - 830 on this index. Oil stocks had a strong day yesterday, and in addition to this rise starting to compensate for the excesses of the preceding plunge, it also anticipates a rally in crude.
The long-term 7-year chart for the OIX oil stock index is very interesting, as it reveals why the rout ended where it did, although it obviously ended when the broad market plunge stopped. On this chart we can see that, on a closing basis, the steep drop stopped exactly at the long-term uptrend line. On the face of it this looks good, as the long-term uptrend held, and while it is now reasonable to expect a significant short-term relief rally to alleviate the current deeply oversold condition, there are a couple of warning signs that the the long-term uptrend may end before much longer. Before considering these a general point needs to be made, which is that although oil prices, like most commodities, will benefit from rampant inflation, which the USA and many other working are working assiduously to generate, they are certainly not helped by the drop in demand that would result from a severe recession/depression such as now seems inevitable. While a recession/depression would be expected to result in an at least temporary reduction in demand for oil, probably resulting in a bear market, even if only mild, the associated severe drop in stockmarkets would have a far worse impact on oil equities, which as we have seen dramatically demonstrated this month, could plunge out of all proportion to the drop in oil prices. For this reason, despite the immediate prospects of a short-term rally, Precious Metals stocks are regarded as broadly much safer investments than oil stocks. When the acute and ongoing systemic crisis in the world financial system takes center stage again - which it is set to do repeatedly, massive damage will be inflicted on stockmarkets, and as time goes by the flight to safety will be increasingly in the direction of the Precious Metals, rather than into commodities the demand for which is dependant on a healthy world economy, such as oil.
The warning signs that the long-term uptrend in oil stocks may break down before too much longer are the convergence of the long-term uptrend channel shown on the 7-year chart, which indicates that the uptrend is declining in vigor, and the severity of this month’s plunge back to support at the lower channel line, which sort of action frequently portends a breakdown. Thus, while we can expect a worthwhile tradable bounce in oil stocks short-term, we should not be too greedy when the time approaches to take profits, and should be on the lookout for signs of long-term uptrend failure. However, until the long-term uptrend line is clearly breached, it is prudent to assume that the major uptrend remains in force.
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