After powering above $85
per barrel this week, crude oil is one of the hottest commodities
around. Although this week’s stellar prices haven’t yet
reached oil’s all-time inflation-adjusted highs near $100 from
way back in spring 1980, these new nominal record prices are really
getting speculators’ blood flowing.
Nearly everyone is bullish
on oil, and for very good reason. Global demand, led by the
rapidly-industrializing Asia, is growing
relentlessly and will continue to do so for decades. Meanwhile existing
oilfields are increasingly depleting, lowering production and raising
costs. And despite vast sums of money poured into oil exploration
globally, major new elephant finds have become exceedingly rare. And
most of the world’s known oil reserves sit in geopolitically-troubled
regions, complicating recovery.
With worldwide demand
heading inexorably higher, and worldwide supply
getting pinched ever tighter, the only economic option for oil is a
continuing secular bull market. Typically higher prices curtail demand,
but this has definitely not been the case in oil so far. Since goods
and people simply have to keep moving worldwide, the costs of
transporting them are largely irrelevant.
Until oil prices get high
enough and stay high enough for long enough for technological
alternatives like synthetic fuels to really become commercially viable,
global demand for crude oil will remain extraordinarily inelastic relative to
its price. And since virtually all the oil pumped is burned for fuel
soon after, there are insufficient above-ground global stockpiles to offset
the shrinking gap between daily supply and demand.
For these reasons, oil
really is the perfect bull market. I can’t even imagine more
bullish fundamentals persisting farther into the future than crude oil’s today. And oil is the only secular bull
market that I have trouble dreaming up end-of-bull scenarios for. Eventually
years into the future, production of precious metals, base metals, and even
uranium will catch up with and exceed demand ending their bulls. But
oil is so hard to produce in the vast quantities our world needs that its
bull run often seems quasi-perpetual.
But although this oil bull
is exceptional fundamentally, it hasn’t miraculously escaped the
chaotic winds of sentiment. No bull, no matter how long it lasts nor
how high it climbs, ever makes its journey in a nice straight line. Greed
and fear constantly buffet its journey, rendering a sawtooth
pattern on its chart. Bulls take two steps forward until greed peaks
and then they retreat one step back until fear peaks. And then this
cycle repeats ad infinitum as long as underlying fundamentals remain
bullish. Oil is no exception.
If fundamentals lead a price
to travel in a fairly straight line climbing to the right, ever-shifting
sentiment pulls this line into a sine wave oscillating around its primary
uptrend. While these bull cycles can be stressful for those not
anticipating them, they offer great opportunities for prudent traders. Speculators
and investors alike can buy low at the bottoms of these waves, getting the
best prices in a bull. And speculators can sell high at the top and
wait for the next bottom to buy again.
In light of today’s
incredible excitement surrounding oil, and extreme bullishness, we are
probably near the top of one of these sentiment waves today. Greed is
running rampant and most traders can’t even imagine a sharp correction
in oil given today’s fundamental and geopolitical scene. Yet it
is always just when traders least expect it that sentiment shifts for a
season. And in oil, these shifts tend to be fast and unforgiving.
So anyone trading oil
futures or the stocks of the companies that produce it needs to keep this oil
bull’s cycles in mind. Since I am both a long-term investor and
short-term speculator in oil stocks, oil’s near-term probabilities
greatly interest me. Do the odds favor me
adding long positions today in line with general bullishness or holding off
on any new deployment until after a major correction?
In order to address this
critical question, the sentiment-driven sine waves we have already witnessed
in this oil bull to date must be studied. While the past never predicts
the future precisely, it really does help define what is possible and
likely. Since the emotions of greed and fear will always exist and
vie for temporary dominance, the oil bull cycles show the general extent to
which emotional extremes affect prices.
This first chart quantifies
these cycles, illuminating the sawtooth pattern
carved by greed-driven uplegs and fear-driven
corrections. Although today’s secular oil bull technically launched in late 1998 from just under
$11 per barrel, between late 2000 and late 2001 a powerful cyclical
bear interrupted this bull. It is from these 2001 interim lows of just
over $17 that the current phase of our bull started. So there we begin
this study of the oil bull cycles.
Each upleg
and correction of this oil bull since 2001 is marked on this chart. For
each major move, its absolute gain or loss as well as the number of months it
took to run its course is noted. In order to define these major upleg-correction cycles, I generally considered uplegs to be runs exceeding 20% and corrections to be
retreats exceeding 15%. This approach yields 9 major completed uplegs and corrections since late 2001, with oil’s
10th major upleg now maturing.
One of the most
entertaining aspects of this oil bull for me is watching traders and analysts
talk about it on CNBC. Invariably whenever the oil price is forging new
bull highs, they articulate ironclad bullet-proof cases about why oil can
only go higher. Rather than looking at the hard evidence of history and
being contrarian when greed waxes extreme, like weathervanes they simply
reflect the general sentiment swirling around them.
But this fascinating oil
chart does not have an emotional bias. It shows a very powerful secular
bull, no doubt. But oil’s rise has been as far from straight-line
smooth as you can get. Yes, oil has advanced in very strong and
profitable uplegs. But every one of these uplegs was followed by a hard and fast correction. Inevitably
as any upleg matures, general greed and excitement
grows too great. Once everyone interested in buying around that time
has bought in, profit-taking selling overwhelms anemic
buying and forces a sharp decline.
The 9 completed uplegs of this oil bull run have been incredible. They
have ranged from quick and dirty 25%ish ones to monster runs
approaching 70%. Overall, they have averaged 45% gains in just under 5 months each. These huge potential profits
offered so often over the last six years show why traders are so enamored with this oil bull. Our current upleg, the 10th one, is not considered in these
calculations. Until it has clearly topped in hindsight, its gains must
be considered provisional for now.
But the yin to the uplegs’ yang is the equally frequent
corrections. They have ranged from fairly modest 15% declines to
massive drops exceeding 30%. Now 15% to 30% may not seem too
apocalyptic, but remember futures traders are highly leveraged with
margin. These corrections, if not anticipated, are greatly amplified by
this margin. Overall the average correction has lopped 22% off the oil
price in just 2 months. If such a garden-variety correction happened
today, oil would fall under $68 before Christmas.
So this bull-to-date
precedent is crystal clear. Yes oil rallies mightily in its uplegs, but the cost of these gains is the inevitable
subsequent corrections that bleed off the widespread greed these uplegs generate. You can’t have an upleg without a correction any more than you can have a
one-sided coin. This is just the nature of the financial markets since
they are constantly tugged back and forth by greed and fear.
Enter our current enormous upleg. As of this week, oil has rallied a
phenomenal 71% in just 9 months since January! Considering how gigantic
the global oil market is, such rapid gains are truly extraordinary. After
seeing such a monster run, today traders seem largely convinced oil is
invincible. Due to oil’s strong fundamentals and perpetual Middle East geopolitical concerns, they don’t see
any correction risk today.
Now before I did this
research, I assumed that this latest 10th major upleg
in oil was unprecedented within this bull. While technically correct,
surprisingly this oil upleg isn’t outside the
bounds of precedent by all that much. Back off its dismal lows of late
2001, oil soared 68% in just under 6 months. Then over 13 months in
2003 and 2004, the King of Commodities rallied another 68%. So as far
as big oil uplegs go, today’s 71% run
isn’t too far outside the realm of precedent.
And interestingly, the
corrections after these earlier big uplegs were on
the small side. Upleg 1 saw an 18%
correction in just under a month while upleg 4
dropped 16% in just under a month as well. Smaller but faster plunges
lower can do as much to rebalance hyper-optimistic sentiment as larger but
slower grinds lower. These corrections end
once fear exceeds greed and most of the sellers have already sold. If
oil corrected a similar amount today in its current big upleg,
we’d see $72 before Thanksgiving.
The key point here though
is not oil’s specific downside target nor the duration of its decline,
just that after major uplegs corrections are inevitable.
Traders today not considering the growing risk of such a correction could
find themselves in big trouble since oil’s declines tend to be so sharp
and unforgiving. The less such a sharp decline is expected, the more exciting
oil looks over the near term, the higher the probability for a sudden
correction becomes.
Oil’s most recent
major correction offers an excellent case-in-point here. In July 2006,
oil soared to $77 on geopolitical concerns out of the Middle East as well as
supply disruptions like the corrosion problems in the Prudhoe
Bay pipelines. Many traders, including me unfortunately,
were very bullish because oil
tends to be strong seasonally in August and
September during the late hurricane season. Oil looked ready to climb
for another month or two before it corrected, but alas this was not to be.
Even though oil was not
overbought technically in July 2006, even though that 9th upleg
had only climbed 34% higher, general euphoria had ballooned too high so oil
corrected anyway. And it was a particularly brutal correction, the
worst seen in this bull so far. Oil plummeted nearly 35% in just over 6
months before finally managing to bounce at $50 in mid-January of this
year. This not only hammered oil futures traders, but oil-stock traders as
well. We had a bunch of oil-stock call options expire at losses.
This 9th oil correction was
all the more remarkable because it
easily pierced oil’s support line, rendered above. Trading losses
aside, this was actually a rather amusing episode academically. Since
the newest CRB commodities index is
utterly dominated by oil, commodities
gloom-and-doomers came out of the woodwork to
declare the ends of various commodities bulls in late 2006. Many of
their bearish theories rested on the newly-revised CRB that was nothing
like the historical CRB they so
casually compared it to.
But a correction within a
secular bull, no matter how sharp or how technically ominous,
doesn’t mean the bull is over. All it means is general fear rose to an unsustainable extreme driving unwarranted levels of
selling. As long as the bull’s underlying global
supply-and-demand fundamentals remain intact, it doesn’t matter how
crazy any correction gets. The single biggest mistake traders make late
in corrections is assuming fundamentals have gone sour rather than the
far-more-likely scenario that the cause
is simply fear-driven sentiment.
So since oil became so
radically oversold in January, we shouldn’t be too surprised by its
enormous reaction rally to dig out of those lows. Most of this newest
10th upleg, as the chart above shows, occurred below
oil’s old uptrend channel. In fact, from just over $50 to just
under $75 merely brought oil back up to its old lower support line. Its
old resistance line, which has repelled the last 5 uplegs
in a row like clockwork, is now in the low $90s. Obviously this
isn’t much higher from here.
But even if oil’s
awesome run higher this year is largely considered to be a reaction rally off
of silly fear-driven lows in January, this doesn’t negate the
inexorable greed-fear waves oscillating through it. Regardless of
whether this run was fully justified fundamentally or not, oil is up 71% in 9
months and traders are extremely euphoric today. When everyone gets
greedy is when corrections suddenly spring forth and trap the unwary bulls
with a vengeance.
Feeding into this thesis
that oil ought to top soon and correct sharply, this commodity is now very
overbought technically. One of my favorite
technical tools is a simple concept called Relativity. In the greed-driven
uplegs of bulls, prices pull far above their
200-day moving averages. And then in the following fear-driven
corrections, prices retreat back down to their 200dmas. So the level of
greed or fear in a bull at any time can be inferred based on where a price is
trending relative to its 200dma.
This next chart looks at
the oil bull compared to relative oil, or oil divided by its 200dma. This
rOil value is rendered with the red line.
After 9 major uplegs and corrections since late
2001, rOil has established a definite horizontal
trading range. By examining how far oil has been able to pull away from
its 200dma in these past uplegs before greed became
too extreme, we can gain a better understanding of the probabilities for a
sharp correction today.
Relative oil just expresses
the oil price as a constant multiple of its 200dma. A value of 1.25x, for example, simply means that the oil price is
trading at 1.25 times its 200dma. Curiously, over time the upleg tops within a given bull tend to cluster around a
certain multiple of their 200dma. In the case of oil, this is 1.26x. While the 9 major uplegs
prior to this one topped between 1.15x to 1.37x
oil’s 200dma, the average rOil top ran
1.261x.
All but the last two
completed uplegs’ tops happened at 1.24x or
higher, so we have long been using 1.25x as the top of our rOil trading range at Zeal. Once oil pulls
away from its 200dma by more than 1.25x, we go
neutral on it and wait for a correction before adding new long
positions. Sometimes rOil can head even
higher than this, but oil still inevitably eventually corrects and contracts
sharply back down towards its 200dma.
In this chart, oil’s
relative trading range is annotated with the same upleg
and correction numbers used above in the bull cycles chart. Today our
latest upleg 10 is trading at 1.288x
over its 200dma. This is exceptionally overbought technically in the
light of bull-to-date precedent. Only uplegs
3, 5, and 7 had rOil tops
higher than what we are already seeing today. These were pretty
sizeable uplegs too, running 50%, 55%, and 44%
higher respectively.
And after stretching so far
over their 200dmas technically, the corrections following uplegs
3, 5, and 7 were pretty ugly. They ran 33%, 26%, and 20% respectively
for a 26% average. Often, but not always, the magnitude of a correction
is directly proportional to the upleg that preceded
it. Bigger uplegs generate a lot more greed
at their tops so it tends to take deeper and/or longer corrections to
dissipate this greed and return balance to sentiment.
Since our current oil upleg is not only the largest in this bull so far but
also one of the most overbought technically, it would not surprise me at all
to see a larger-than-normal correction. At 26% off of this week’s
highs, we’d be looking at $64 oil within a couple months or so. For
traders prepared for such an eventuality, this would prove an awesome
opportunity. But for traders trapped unaware in a sharp decline, they
could really lose their shirts once leverage amplifies their losses.
And it is not just rOil that makes oil look extremely overbought today
technically. I suspect that pretty much any technical tool you want to
apply to oil would also show unsustainable greed evident in its price
today. No bull ever marches higher in a straight line, and oil will
also have to retreat one step back sooner or later to partially offset its
huge two steps forward since January.
Personally, I will start
looking to redeploy into oil stocks once oil retreats back down slightly
under its 200dma again. This would correspond to a level around $65
relative to today’s 200dma. We have long used an
rOil level of less than 0.98x as our signal to
start getting long again in oil-related trades. If you average all the rOil bottoms, they work out to 0.946x its 200dma. But
this was skewed lower by the anomalous super-deep 9th correction of late
2006. Without that, the average rOil bottom
is 0.969x.
Now as every upleg matures, strong arguments are advanced as to why
that particular upleg must continue considerably
higher. Today is no exception. Most of the short-term bullish
arguments for oil today are geopolitical in nature. Analysts are acting
as if current conflicts and escalations are new and exciting. But in
geopolitics, just like in markets, there really is nothing new under the sun.
The Kurds have wanted their
own nation since World War I hopelessly messed up the national boundaries in
the Middle East. With Kurdistan
straddling Turkey and Iraq it is no surprise that Turkey is worried that Kurds in northern Iraq will incite Kurds in southern Turkey to continue fighting for independence
from Turkey.
So Turkey threatening to
send troops into northern Iraq
is certainly nothing new.
And the Arabs wanting to
destroy Israel
is old news too. The Arabs invaded Israel in May 1948, massed on Israel’s border threatening invasion in
June 1967, and invaded Israel
again in October 1973. Realizing how much
its neighbors hated it, Israel
bombed the Osirak nuclear reactor in Iraq in June 1981 before Iraq could nuke Israel. Iraq rained
missiles on unprotected Israeli cities during the 1991 Gulf War. Last
month Israel bombed an
alleged nuclear site in Syria.
Interesting? Absolutely! New? Nope. This conflict has
been grinding on for six decades since the Jews finally returned to their
ancient homeland in 1948.
And despite these big
geopolitical events and countless smaller ones over the years, oil still does
not rise in a straight line. It flows and ebbs like all bulls.
And it will continue to flow and ebb even if, God forbid, World War III
erupts in the Middle East. A big
conflict would certainly accelerate this oil bull, but oil would still need
to correct periodically to bleed off excessive greed. Geopolitical
flare-ups don’t nullify this immutable financial-market trait.
So oil is growing
increasingly overbought, and it will correct sooner or later. At
Zeal, we’ll certainly be ready for this buying opportunity. While
we have been deploying capital to ride the red-hot gold upleg
in recent months, oil and oil stocks are always on our minds. If you
want to be ready for the next big buying opportunity in elite oil stocks that
a major oil correction will bring, please subscribe today to our acclaimed monthly newsletter. It’ll
detail all our latest analysis in the months ahead and our actual oil-stock
trades.
The bottom line is this oil
bull, like every other bull market in history, powers higher in fits and
starts. Yes oil’s long-term fundamentals are breathtakingly
bullish, and yes the Middle East is a mess
geopolitically. But this has been the case for a long time now. Yet
oil’s general upward progress has still been periodically interrupted
by sudden and sharp corrections to rebalance overly-greedy sentiment.
Today we have
once again reached the point where hyper-bullishness in oil reigns. Few
can even imagine it pulling back, let alone correcting hard. But it is
when things look the most bullish, after the strongest runs higher, that
corrections are the most likely to suddenly spring into existence. Oil
and oil-stock traders would do well to remember this as oil euphoria grows
extreme at this stage in the oil bull cycles.
Adam
Hamilton, CPA
Zealllc.com
October
19, 2007
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