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April 21, 2006

Trading the Oil Bull 4
by Adam Hamilton

This past week was one of the most fascinating I have seen in this commodities bull yet. Major commodities were hitting new highs all over the place, both bull-to-date and even all-time records in some cases. Crude oil in particular was blessed with some really exciting price action, achieving all-time-record nominal highs.

As a commodities investor and speculator, I love seeing oil prices rise. The higher they go the better. Not only are they driving enormous profits for the stockholders of the energy companies, but sustained high energy prices for many years are essential to spur new exploration as well as alternative energy research. High energy prices today will help ensure civilization is adequately prepared for the energy needs of tomorrow.

At Zeal we have been heavily exposed in elite oil stocks, both on the investment and speculation sides of our portfolios, since oil's latest interim bottom of late November. Back then I was really bullish on oil stocks for several reasons.

Oil stocks were very undervalued fundamentally, trading at unbelievably low prices relative to the massive earnings they were spinning off. And the primary driver of these stocks and their earnings is of course the price of oil. Late last autumn most investors seemed to wrongly think that $60+ oil was a hurricane anomaly, not a true reflection of a long-term structural deficit where oil demand growth continues to exceed supply growth worldwide.

Once oil's overly pessimistic correction psychology worked through the system, I expected its price to continue to rise to reflect world fundamentals. Last October about a month before oil's latest interim bottom, my technical research in this essay's predecessor led me to believe that $55ish was the most probable bounce point from whence the next major oil upleg would erupt.

Thankfully this target proved reasonably accurate as oil ended up bottoming just above $56 on a closing basis on November 18th. Since then the oil investments and speculations we have layered in have thrived and we and our subscribers have been blessed with excellent unrealized profits.

But after the surging oil action of this week, a big new question is emerging. With all-time nominal oil highs now in the bag, is this upleg nearing the end of its days?

In order to address this question, I updated my technical research on oil this week. Since oil stocks have an incredibly high positive correlation with oil, the oil price action of the next couple months is going to be the most important driver of where our oil stock positions meander. The charts this week are updates from "Trading the Oil Bull 3", the same essay from which my earlier $55ish interim-bottoming target emerged.

One tool I have found very valuable in analyzing ongoing secular bulls is to consider their rhythms. All bulls flow and ebb, rise in awesome uplegs and then correct back down in healthy corrections. Interestingly this pulsing rhythm of gain and loss often creates a repeating pattern. While it cannot predict the future with any certainty since anything is possible in the markets, these secular rhythms can still give us a good idea of where probabilities favor a price heading next.

Strangely, and this surprises me too, secular rhythms have yielded some of the best interim high and interim low targets out of all of our various analysis approaches over the last five years. This is interesting as this tool is very straightforward and easy to employ. The longer I study the markets and the deeper my understanding of them grows, the more it amazes me that often the simplest analytical approaches work the best.

To study the secular oil-bull rhythms, all we have to is carve it up into a series of major uplegs and major corrections in its bull to date. In order to define these uplegs, I used a simple methodology. Any major surge higher where oil ultimately achieves new bull-to-date highs is considered an upleg and marked as such below. And then the inevitable corrections after these uplegs are considered complete when oil hits its lowest point before it starts surging again in its next assault on fresh new bull-to-date highs.

This approach yields 7 major uplegs and 7 major corrections so far in this secular oil bull to date. We are now in our 8th major upleg and oil has just hit new bull-to-date highs, so there can remain no doubt that this latest bullish oil action is the real deal, a full-blown bull-market upleg. And the latest secular rhythm analysis suggests that we still have plenty of room left to run yet in probability terms.

As a real-world example of the efficacy of secular rhythm analysis, let's consider the red corrections rendered above first. Back in October when I wrote my last essay in this series, it looked like we were well into correction mode and hence I was looking for the next major interim bottom near which to buy. Back then I wrote...

"The six major bull-to-date corrections noted above with the red arrows had an average loss of 21%. There is no real pattern here like there was for oil's individual upleg gains moderating as this bull matures, so 21% is as good of correction target as any. Oil's latest interim high was just under $70 on the day after Katrina slammed into the Gulf, so a 21% correction here would carry it down to $55ish. But so far it has only corrected 12% since August 30th."

Simple eh? This isn't rocket science, but the oil bull's ebbing rhythm suggested six months ago that the latest correction had the highest probability of falling 21% peak to trough before oil's next upleg launched. On this latest chart above, you can see what actually happened. Oil fell 20% in correction 7 before bouncing, really pretty close to its secular rhythm target. While anything can happen in the markets, secular trends often tend to follow their own rhythm.

Using this same approach today as we search for the next likely interim top, the 7 major oil uplegs that have gone before us have yielded average gains of 50% over 106 trading days. This offers some valuable insights into how our current oil upleg stacks up compared to its predecessors.

So far oil is only up 28% since its November lows, just over half of the average gain of the 7 major uplegs before it. Stated another way, if we apply the 50% average upleg target gain to the November lows, we get a target for the next major interim high just above $84. So per this oil bull's secular rhythm, oil still has considerable room to run yet in probability terms even if this upleg proves to be merely average. This ought to encourage investors and speculators remaining long oil stocks and options.

Unfortunately the average duration suggests this oil upleg is more mature than its price gains suggest. Bull to date the average oil upleg has lasted 106 trading days, with most uplegs being considerably shorter. The only really long upleg happened in late 2003 and early 2004 and oil didn't start ascending in a steep upslope until the very end of that upleg 4. Today our latest oil upleg is 102 trading days old, undeniably mature in duration terms.

While this is definitely a risk to consider, I don't think it would be too hard for oil to witness a longer upleg today than it generally has since 2001. The primary reason is we are not in crisis mode today. Crises tend to drive fast moves up and fast corrections afterwards. Yes there are rebels in Nigeria blowing stuff up and Iran wants to defend itself against nuclear-armed imperialists, but oil supplies really aren't that constrained. Today the hurricanes aren't flying into the Gulf of Mexico and ballistic missiles aren't flying across the Persian Gulf.

I suspect the truth is slowly dawning on Wall Street and mainstream investors that high oil prices are here to stay for rock-solid supply and demand reasons. For years investors generally thought that oil prices would only head higher if some country in the Persian Gulf decided to annex one of its neighbors. But the reality is, especially with the rise of Asia, that world oil supply growth simply cannot keep pace with demand growth. This would be the case even in a perfectly peaceful world where every man loved his neighbor unconditionally.

Interestingly it was only in December when the US government finally officially acknowledged that oil prices should stay above today's levels in real terms for the next quarter century. Up until that point the US government had officially predicted oil fairly rapidly returning to the mid-$30s in real terms for the next 25 years. I still believe that this official US government acknowledgement of reality is gradually helping investors understand the truth.

If you think of your mainstream friends who have not been following this commodities bull since early 2001, many have just not had the opportunity to look into the global structural deficits in key commodities. Gradually they are starting to pay attention as mainstream media like CNBC devotes more time to the commodities bull, but at this point the mainstream capital shift into commodities has barely begun. Thus it seems reasonable to assume that this and future oil uplegs could last longer in terms of trading-day duration as more capital floods in.

So in secular rhythm terms oil is currently only just above halfway to even being considered merely average relative to its bull-to-date predecessor uplegs. And while it is getting long in the tooth by bull-to-date average standards, this may not be a problem. Thus this line of analysis leads me to conclude that oil and hence oil stocks are in no danger of topping in the immediate future. We should have a couple months or so to run yet.

Before we move into my final chart this week, I have one more observation on this one. I've been hearing from investors concerned that oil prices have risen too fast since early March. This may indeed be the case and we might need a minor pullback to address this, but definitely not a major correction. If you carefully examine the previous 3 major uplegs, numbered 5, 6, and 7, it is readily evident that all three had steep upslopes much like today's upleg.

When viewed in the strategic context of its bull to date, today's upleg in oil blends right in and doesn't seem anomalous at all. The steepness of its current upslope is merely normal. If you want to see an anomalous surge, take a look at a silver chart. As I have been warning for weeks now, silver has gone short-term parabolic and the aftermath of such an unsustainable surge is never pretty. Zeal subscribers can access our latest silver charts in the private charts section on our website.

Next I'd like to take a look at the latest Relative Oil chart. Relative Oil, or rOil, takes the price of oil and divides it by its 200-day moving average baseline. The result is the red horizontal trading band defined below. Per Relativity trading theory, major uplegs in any secular bull tend to give up their ghosts and hit an interim top near similar relative levels as their predecessors. Today this rOil indicator remains nowhere close to its upper neutral zone.

For years now, I have considered an rOil reading of 1.25x+, or when oil trades 25%+ above its 200dma, the point in time when investors and speculators should become neutral on oil and be preparing for its next major correction. This chart makes it pretty clear why. The blue numbers here correspond to the same major upleg interim tops discussed above and every single one happened near this relative neutral zone. The average rOil top in the first 7 major crude oil uplegs was 1.286x oil's 200dma.

But at its high point during this past week, the best our current upleg could manage to squeeze was 1.148x oil's 200dma on a closing basis. Not only is this just a little over halfway to the top of oil's relative trading range, but never before in this bull has a major oil upleg ended at such low levels. Yes, oil did have a sharp pullback in February from similar relative levels, but this was just a pullback within an upleg and not a major correction between uplegs.

Thus relative oil, interestingly enough, nearly perfectly corroborates the message of oil's secular rhythms. While oil certainly could fail here because anything is possible in the markets, the probabilities based on what oil has done so far in this bull surely conspire against it. As a battle-hardened speculator and investor I have no problem remaining heavily exposed to oil-related longs while probabilities remain in my favor.

One more point about this chart. While we have long been using 1.25x rOil as the top of our relative trading band, we had been using 0.95x as the bottom. But as I analyzed this chart this week, I realized oil has only seldom approached 0.95x its 200dma at major interim bottoms in recent years. Like all technical tools relative trading ranges need to be adjusted periodically, and I think that raising the strong-buy green band from 0.95x to 0.98x oil's 200dma will better reflect oil's behavior over the last few years. This rOil range change will filter into the upcoming editions of our newsletters and subscriber charts.

Back to the task at hand, even if oil would enter a consolidation here, trade sideways, the oil stocks probably wouldn't take too much of a beating. Oil companies have been earning massive profits in the $60s so if oil could linger around $70 or higher for a quarter or so the stocks' already low valuations would be driven even lower. It is probably only a sharp oil correction that could spawn enough fear to lead to widespread oil stock selling even despite this sector's incredibly strong fundamentals.

And these fundamentals coupled with the oil weakness back in November, December, and February led to some absolutely amazing buying opportunities on which we eagerly jumped. From November to March we launched oil stock call-options trades in 6 different elite oil stocks in our Zeal Speculator alerts service alone. As of the middle of this week, our average unrealized gains across all of these oil stock call-options positions were running 174%.

We have also been blessed with excellent unrealized gains in oil stocks as well, both in our long-term investment and short-term speculation portfolios. The reason I so love being a lifelong student of the markets is all this research inevitably leads to uncovering awesome real-world trading opportunities for us and our subscribers. Applying this research to building real-world wealth is our primary mission at Zeal.

If you want to see commodities-bull research like this essay applied to recommending high-potential-for-success real-world trades near opportune entry points, please subscribe to our acclaimed monthly Zeal Intelligence newsletter today. Many more awesome commodities-stocks buying opportunities are approaching and you may as well ride this great bull to multiply your wealth rather than simply lamenting the high commodities prices.

The bottom line is this current oil upleg, when viewed in the context of the 7 other major oil uplegs that came before it in this bull, does not look like it is near a major interim top yet. While it could pull back within this upleg temporarily to rebalance sentiment, neither its gains so far nor its degree of stretching above its baseline 200dma have even approached bull-to-date averages yet. Oil does not look overbought.

And as goes oil, so go the oil stocks. Continuing higher oil prices are going to lead to record Q1 earnings and I can't wait to see all the oil companies' earnings reports which will soon be released. When investors see yet another quarter of record oil profits, there is a good chance more mainstream capital will flood into these oil stocks driving our existing unrealized profits even higher.

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

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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