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Oil Market Update

Clive Maund
September 23, 2008

In the last update we had expected the important support at and above $110 on the Light Crude chart to hold, but it didn't, and its failure led to a rapid plunge back to a point very close to $90. Just how important this support was is clear on the 3-year chart for Light Crude on which we can see that the drop beneath $110 resulted in a break below the 200-day moving average and a breakdown from the long-term uptrend in force from early 2007. The failure of this uptrend by a big margin raises the question of whether the bullmarket in oil is over.

The steep and substantial drop from the highs to a level not far above the lows of January and February of this year has resulted in an as yet incomplete pattern that looks like a Head-and-Shoulders top in the making, with the big drop being the right side of a large Head, and the sharp rally of recent days from deeply oversold being the left part of the nascent Right Shoulder. If that is what this pattern really is then the current rise is presenting a last chance to get out at reasonable prices before a protracted decline sets in. It is of course too early to say with any degree of certainty as Head-and-Shoulders top patterns sometimes abort, as happened famously with the huge example in the S&P500 index in 2003. However, it is certainly worth bearing in mind, particularly given the bearish implications of the support and long-term trendline failure already described. This interpretation raises a big question, for you may already have read the latest Gold and Silver Market updates, which are bullish, and as we know gold and oil generally move in lockstep, at least as regards their long-term trend. So how can the outlook for Precious Metals be bullish, and the provisional outlook for oil be bearish at the same time? The explanation for the divergence is that, as described in other articles on the site and by other leading writers, we are on the verge of absolute chaos in the world financial system which is likely to lead eventually to severe recession or depression in many countries, possibly after a period of very high inflation first. The flight to safety will channel money into the Precious Metals, the demand for which, at least in the case of gold, is not driven to any great extent by industrial usage. The demand for oil, on the other hand, would be likely to drop back dramatically in the event of a severe recession. In this situation gold and silver could advance strongly at the same time as oil declines in a bear market.

On the 6-month chart for Light Crude we can see the severe decline in the price from the July peak, and how it was punctuated by a deceptive pause in August. The failure of the support level shown above the 200-day moving average was clearly an important technical event that has turned this support into a zone of supply that should, at least temporarily, cap the current advance and will probably lead to a reaction. As is plain on this chart the current snapback rally followed critically oversold readings on the RSI indicator and an extremely oversold condition shown by the MACD indicator. Now, with the price approaching the zone of resistance after a very sharp rally, a reaction looks very likely soon.

The 3-year chart for the OIX oil stock index shows that oil stocks have actually held up comparatively well, given the heavy losses in most other sectors in the recent past. This is hardly surprising given that oil companies are awash in a sea of cash resulting from years of rising prices, and no doubt feel deep gratitude to the present Rebublican administration in the US for its 8 years of service to the oil industry. Nevertheless there are warning signals being flashed by this chart that the days of plenty may be numbered. The big one is that the recent heavy reaction has brought prices right back to their lows of early this year and the middle of last year, creating a potential top area that thus far can be classified as a Flat-bottomed Broadening Formation, which is bearish, although there is some chance that the pattern may evolve further into a complex or multi-shouldered Head-and-Shoulders top, which could involve the index rallying to 850 or even the 900 area. In any event the crucial strong support shown, which would be the "neckline" of a Head-and-Shoulders top, must hold - if it breaks by a significant margin it will signal a bear market.

The 6-month chart for the OIX oil index shows the downtrend in force from early July, with the index running into trouble again at the downtrend line. Even if it succeeds in breaking out of the downtrend, it will face quite heavy resistance approaching 850 and again in the 900 area, which is the vicinity of the early January high, where a potential Right Shoulder for a Head-an-Shoulders top could form.

Finally there are two factors that we should keep in mind that could yet result in big gains in the price of oil. One is the current hyperinflationary stance of the US Fed and government, which is unlikely to change as the only alternative is a credit freezeup and deflationary implosion. They stand ready to create whatever money is necessary to prevent the failure of any corporation or institution in the US big enough or important enough to take down the system. This takes alot of money and as foreigners` appetite for worthless paper and IOU's in the form of Treasury Bonds etc is waning fast, that means that the government is increasingly going to have to buy them itself, which is kind of similar to the scene in an old silent film where a wheel falls off a car while it is driving along, and an occupant of the car leans out and holds the car up by its axle - nice idea but poor physics. Thus, the government buying its own paper will quickly create a hyperinflationary spiral. In this situation, the dollar nominal price of oil and many other commodities would rise, even if their actual value remained the same or fell.

The other factor that could cause a huge rise in the price of oil would be if the current game of brinksmanship between Russia and NATO, and especially the US, gets out of hand leading to real conflict. Russia is fed up after years of encroachment and the construction of numerous military bases close to its borders by the US, particularly in south-central asia, and the so-called missile shield in Poland, whose true target is obviously Russia. This was the reason for the Georgia episode and is the reason for the current "Caribbean cruises" by heavily armed Russian warships. History is replete with examples of countries with big militaries like the US, faced with severe economic problems at home and an increasingly restive population, diverting attention from these problems by engaging in conflict with external enemies.

Clive Maund

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

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