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June 06, 2008

Gaming Oil Corrections
by Adam Hamilton

Without a doubt, crude oil is the most important commodity on our planet. Hypothetically if it vanished overnight, our entire modern world would collapse. No goods could move without the oil-derived transportation fuels, so virtually all trade would implode. Unlike nearly every other major commodity, there is just no economically-viable substitute for oil.

And the fundamentals driving oil's secular bull are unparalleled in their strength. As Asia awakens and enters the modern era, global demand for oil is rising relentlessly. Despite today's unprecedented prices, demand remains strong all over the world. And of course once oil is burned, it is gone forever.

But supply growth just can't keep pace with demand growth. Finding big new oilfields has become exceedingly rare. You can count the major finds in the last several decades on your fingers! And the new oil that is found these days is almost always remote and extremely expensive to recover and bring to market.

Oil's meteoric ascent has certainly reflected its ultra-bullish secular fundamentals. Between November 2001 and May 2008, it soared 666.3% higher! Granted, about half these gains in dollar terms were due to the Fed's relentless fiat-currency inflation, but oil has still been a monster bull. It is amazing that this giant market has utterly dwarfed the bull-to-date gains of far-smaller and more-speculative commodities like silver.

But even though oil sports the most bullish secular fundamentals of any major commodity, it didn't travel from $17 to $134 in a nice straight line. Like all bulls, oil has flowed and ebbed. Massive uplegs that drove widespread greed yielded to subsequent brutal corrections to rebalance sentiment. Heeding this ironclad characteristic of all secular bulls is more important today than ever.

From January 2007 to May 2008, crude oil soared 164.9% higher in the biggest single upleg I've ever seen. It was gargantuan! Oil did have a couple of brief respites within this 16-month span, but no real correction. Last August it fell 11.4% from its preceding high before powering higher again. And by early February 2008 it had retreated 12.4% from its latest interim high before its upleg resumed.

Now these 11% and 12% pullbacks may seem meaningful if you haven't studied oil's behavior in this bull. But they are really pretty trivial, especially relative to oil's recent massive gains. Since late 2001, there have already been 9 major corrections in this oil bull. There are a few criteria I usually use to define a "major correction" whenever I study bull-market cycles with the intent of actively trading them.

First, a major correction can only come after a major upleg. The job of a correction is to erase the excessive greed the preceding upleg fomented. Second, oil had to be at or near a bull-market high at the preceding top to give a decline major-correction status. Third, oil had to be technically overbought at the same preceding top which provides evidence of excessive greed. Finally, a decline has to run 15%+ to enter major-correction territory. Anything less is simply a minor mid-upleg pullback.

If you imagine a bull-market uptrend as a rising straight line, the uplegs and corrections are like a sine wave that oscillates around it. From time to time speculators get excited and drive prices well above this trend, an upleg. But ultimately their greed peaks and burns itself out and prices plunge, a correction. Then speculators grow depressed and continue selling until prices fall well under this trend. A bull-market price chart is a chronicle of the endless manic-depressive nature of traders, the greed-fear-greed-fear cycle.

This first chart documents these sentiment cycles witnessed in this secular oil bull. While it may seem like oil does nothing but climb after witnessing this past year, this is certainly not true. Although oil has been rising on balance, its long climb has been plenty volatile and chaotic. And its healthy periodic corrections necessary to rebalance sentiment are often large and sharp. Caveat emptor!

Prior to upleg 10, the giant 164.9% current one that may have just peaked in late May, the average oil upleg ran 45.4% higher over 4.9 months. There were some bigger ones, running 68.3% and 67.7% higher, but our current one is so far outside the bounds of precedent that it defies belief. If these 9 earlier smaller uplegs could spawn such major corrections, how big of correction could our current epic upleg trigger?

The average oil correction in the pre-upleg-10 era of reasonably-sized uplegs fell 21.8% over 2.0 months. The larger corrections pushed 33% to 35%. And most of these major oil corrections unfolded rapidly, in 1 to 3 months. So today's oil traders need to realize that not only has oil not gone up in a straight line, but when it corrects from time to time these downdrafts tend to be fast and large.

Probabilities certainly favor major correction 10 following this precedent. Sharp corrections are not only par for the course for oil, but they are endemic within virtually all secular bulls. To have oil climb 165% higher for 16 months without major interruption radically raises the odds that a major correction is imminent if it has not already started. And it may indeed have. Note oil's sharp decline over the past couple weeks.

From early February to late May alone, oil rocketed a staggering 53.6% higher! This equates to an average rate of ascent of 0.7% per day, extremely high. In the stock markets, the most powerful rallies ever witnessed are the sharp surges off major bear-market lows. In 2001 and 2002 during 4 huge bear rallies, the S&P 500 only managed average daily gains of 0.6% per day. It amazes me that oil has easily exceeded this!

With crude oil climbing faster than the biggest rallies ever seen in stocks, greed is obviously waxing extreme. No matter how bullish oil's long-term fundamentals are, they simply do not change quickly enough to warrant nearly 4 months' worth of extraordinary 0.7% average daily gains. By late May oil was extremely overbought, as we'll see in the next chart a bit later, and very ripe for a major correction to rebalance sentiment.

And the next major correction, this bull's 10th, is probably already underway. Oil surged 3.7% on May 21st alone to nearly $134, an all-time high. Such a gigantic daily gain is another sign of bull exhaustion and peak greed typical at an upleg's apex. In the 9 trading days following that peak ending June 4th, the data cutoff for this essay, oil has already fallen 8.6% on a closing basis.

This decline is interesting to compare to upleg 10's minor pullbacks ending August 2007 and February 2008. By their 9th days, they were down 8.4% and 7.7% respectively. So while our current decline is only a little steeper than the 8.1% average of the minor pullbacks so far, it is still the sharpest seen in this upleg. If oil hopes to only weather a minor pullback, it is do-or-die time today. If oil doesn't recover, it will soon be in full-blown major-correction mode.

And applying the percentage declines from the 9 previous major corrections of this bull to the latest interim high in late May offers some insights on potential downside price targets. If upleg 10 merely witnesses an average correction, it would fall around 21.8% to $105 or so by late July. By then oil's 200-day moving average, which has stopped many corrections in this bull, will also be running near $105. In secular bulls 200dmas usually, but not always, offer strong support.

Major correction 9, the one that ended with oil near $50 in January 2007 and birthed the enormous upleg 10, was the biggest correction yet seen in this bull at 34.5%. If oil's 10th major correction falls a similar amount, we'd see $88 oil before it ended and the next major upleg began clawing higher. Interestingly, this is about where this oil bull's secular support line is running today.

So based on bull precedent, we ought to see oil trade somewhere between $88 and $105 before major correction 10 fully runs its course. And these projections are likely conservative. While not readily apparent in this oil bull alone, across all secular bulls there is a definite tendency for symmetry between a major correction and the major upleg that led to it. Bigger uplegs naturally tend to beget bigger corrections.

And since upleg 10's stellar 164.9% run was so vastly larger than the 45.4% average or even the previous 68.3% champion, it wouldn't surprise me one bit to see a considerably larger-than-normal oil correction. While correction lows below $90 are unlikely to last for long, much like the brief spike down to $50 in correction 9's terminal phase in early 2007, such deep lows are certainly possible.

Where this oil bull was well-behaved within its secular uptrend until correction 9, that particular correction drove it well under trend. It was kind of funny, as by early 2007 most mainstreamers and plenty of contrarians were declaring that the global commodities "bubbles" had burst. Bad call there! Sentiment was so bad temporarily that it drove prices far lower than they should have gone and laid the foundations for the next huge upleg.

And after oil fell to those far-too-deep correction-9 lows, it soared heavenwards in major upleg 10. So as you can see in the chart above, since late 2006 oil has been oscillating around its previously-established secular uptrend channel. If these giant oscillations outside of oil's uptrend continue, then major correction 10 will indeed be considerably deeper than bull precedent alone would suggest.

This case presented so far may lead you to believe that gaming oil corrections is easy. But it certainly isn't. I thought oil upleg 10 looked very toppy back in late October 2007 when it hit its secular resistance near $95 after a then-stupendous 91.5% upleg in less than a year. I wrote an essay on this back then and initiated some exploratory trades on the short side of oil. Although oil did retreat 9.2%, it soon started consolidating high and never entered the major correction I expected between November and January.

But such is speculation, we can only game the future based on probabilities. No certainties exist. But the fact that oil didn't correct in early November when it arguably should have certainly doesn't negate the correction thesis today. The longer that any major upleg rises without a correction, the greater the odds grow that the correction is imminent. Corrections follow uplegs as inevitably as night follows day.

If you stretch a rubber band farther than you originally expected, does that imply it can stretch infinitely? Of course not. If you stubbornly refuse to sleep for a night, does each additional hour awake increase the odds that you will never need sleep again? Quite the contrary! The bigger an upleg gets and the longer it persists, the greater the odds its end is near. Fighting these odds doesn't nullify them, it just increases the inevitability they'll catch up. All uplegs eventually end, even within the mightiest of bulls.

And the sheer technical extremeness of oil's 10th upleg in late May was incredible. While there are lots of ways to measure how overbought or oversold a price is, I prefer my Relativity trading theory for analyzing upleg-correction cycles within ongoing secular bulls. It expresses a price as a constant multiple of its trailing 200-day moving average. This multiple forms a horizontal trading range across a secular bull.

Relative oil, the oil price divided by its 200dma, has indeed formed a horizontal range over the course of this bull. Most of the time when rOil fell below 0.98x, traders should have been looking to throw long the oil complex for an imminent upleg. Conversely most of the time when rOil climbed above 1.25x, traders should have been anticipating a coming shorting opportunity at a major upleg top. These rOil extremes obviously help to define major uplegs and corrections.

Back in early November, rOil hit its highest levels seen in this entire bull at 1.385x. Prior to that, the average rOil top marking the end of a major oil upleg was much lower at 1.261x. This is one of the key reasons that oil looked so darned overbought in early November. But it refused to correct then, instead entering a minor pullback and then consolidating high between the upper $80s and $100 or so.

This high consolidation gave oil's 200dma time to catch up, so by early February rOil had fallen to 1.092x. This modest level showed oil's price then exhibited no signs of overboughtness or oversoldness. But as soon as oil started surging higher again in mid-February, the rOil multiple started to expand. Finally on May 21st, that huge 3.7% up day that looked terminal, rOil soared to its bull high of 1.413x!

Examining the red rOil line in this chart will give you an idea of just how extreme 1.41x rOil truly is. It is exceedingly rare to see any major asset stretch that far above its 200dma no matter how powerful its bull happens to be. This stellar rOil high shows incredibly excessive greed surrounding the May high and adds additional support to the thesis that oil is way overdue for a major correction to bleed off this greed.

As greed and fear pulse through secular bulls, prices stretch above 200dmas in uplegs driven by greed. And then they retreat back to 200dmas in corrections driven by fear. We haven't seen any real fear in oil since late 2006 or early 2007, a long time ago. But we will, as extreme fear eventually follows extreme greed in this upleg-correction cycle.

With an oil correction long overdue for sentiment, technical, and upleg-correction-cycle-precedent reasons, it certainly makes sense for traders to game this high-probability eventuality. Thanks to the surge in innovative ETF-type trading vehicles, there are many ways for stock traders to bet on an oil correction today. We have been discussing these, and launching trades in them, in our monthly and weekly newsletters lately.

Provocatively, the growth in ETFs could be another factor amplifying correction 10 beyond the magnitude of its predecessors. The primary long-side oil ETF trading in the US today is the United States Oil Fund. USO launched back in spring 2006, and it took some time to grow popular. So the mighty 165% upleg 10 was the first oil upleg to emerge in this new era where stock traders were comfortable buying USO as a long-oil proxy.

In order for any ETF to actively track its underlying asset, there has to be a mechanism for supply/demand differentials in the ETF to be transferred to the asset. For instance, if stock traders bid up USO much faster than oil itself is rising, the ETF threatens to decouple to the upside and fail its tracking mission. So USO's custodians shunt this excess demand into oil to maintain tracking.

This is accomplished by issuing more shares. The new shares help to absorb the excessive demand in the ETF relative to the asset, slowing its disproportional ascent. With the cash raised from issuing these shares, the ETF's custodians buy more oil futures. So demand for actual oil increases too which helps close the gap between the ETF and the asset. Excessive stock buying pressure flows through the ETF to ultimately bid up oil futures. All ETFs work this way to stabilize demand differentials and ensure tracking.

But effectively giving indirect access to futures markets for stock traders' vast pools of capital is a double-edged sword. If falling oil prices scare stock traders more than futures traders, USO could start plunging faster than oil and threaten to decouple to the downside. Its custodians would be forced to react to maintain tracking. They will buy back ETF shares to soak up excess USO supply. And they'll raise the cash for these purchases by selling their oil futures.

This effectively shunts excess USO selling directly into the oil market, amplifying any downside that scares stock traders into selling faster than futures traders. The point of this digression is that the 10th oil correction could be pretty severe if stock traders get scared and start aggressively selling USO. Flight capital out of long-oil ETFs will exacerbate normal futures selling and accelerate any major decline.

At Zeal in the last couple weeks we've been launching various trades anticipating this overdue oil correction. So far they are really thriving. And if oil corrects as far as it ought to, the biggest gains are yet to come. And since oil corrections tend to happen quickly, these trades could easily mature to harvest in the next few months.

If you want to learn about all the trading opportunities an oil correction opens up, and mirror our trades, subscribe today to one of our newsletters. We have an acclaimed monthly more geared towards investors and a fast-moving weekly designed for active speculators. In both products, we apply all of our research towards realizing profitable real-world trades based on current financial-market conditions.

The bottom line is oil is way overdue for a major correction. It doesn't matter how bullish oil's fundamentals happen to be. All bulls correct from time to time to rebalance sentiment and this oil bull has certainly been no exception. Traders must expect major corrections periodically. Not only can these be actively played to the downside, but the best buying opportunities of entire bulls emerge out of correction lows.

Since corrections are normal and healthy, it is irrational to fear them. And thanks to the proliferation of hybrid trading vehicles like ETFs, it is easier than ever to bet against oil with normal stock-trading accounts. And if oil is indeed entering its 10th major correction, this group of trades ought to be among the best-performing commodities-related plays of the summer.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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