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January 06, 2007

Oil and Gas: Whats the story for 2007?
by Clif Droke

It's funny how ever bull market has to have a fundamental story wrapped around it before it can be sold for public consumption. Much like a candy bar at a convenience store, a bull market in stocks or commodities is always packaged with an enticing wrapper designed to lure prospective buyers and ensure its quality to the consumer.

The financial markets operate on much the same principle. A steady upward trend in prices in a major commodity such as oil or natural gas is never conveyed to the public through the mainstream press unless decorated with the most glowing terms to explain just how and why prices are rising. (To a momentum or trend trader, of course, it doesn't matter "why" prices are rising - merely that the fact that they are rising is all he needs to know). But the public is a little more demanding than the mere speculator and must always have answers to explain the supposed reasons behind any bull or bear market.

By concentrating on just the major trends in the oil and gas market of the past 30 years you will see that every major move in the energy sector has been "wrapped" in some fundamentally-based story of one sort or another. The rising energy prices of the 1970s were accompanied by a plethora of news stories and best-selling books describing the impending "oil shortage" and other energy-related scary scenarios. Everyone was told back then that America's oil and coal reserves were being rapidly depleted and that so-called "fossil fuels" would vanish within their lifetimes. Miraculously, these scare stories vanished into thin air when the disinflation of the 1980s gained a foot hold over the financial markets, and even more scarcely were these stories heard during the deflation of the late '90s.

During the brief encounter with deflation of the late 1990s another type of story was commonly repeated in by the popular press, but this time it was quite the opposite of the stories that were heard 20 years earlier. Instead of depletion, news articles and books began appearing that spoke of super-abundant natural resources. At one point, the top selling book on Amazon.com mentioned the discovery of "self-replenishing" oil wells that would supply a continuous glut of fuel and guarantee super-low energy prices for decades to come. The book's appearance coincided with the exact low in the oil price at around $10/barrel.

Today such talk is almost never heard and if it does happen to be mentioned it is laughed off with contempt. A resurgence of the doom-and-gloom oil shortage scenarios from the 1970s has made its way in the popular literature again. It's currently fashionable to talk of "peak oil" (or even more recently, "peak gas"). Yet how much longer will such talk last? Probably until the oil price makes another plunge or else fails to make a new high within five or six months.

All of this falls under the category of "the more things change, the more they stay the same." Bull markets come and go and the stories used to wrap them for public consumption never change very much in the generalities - only in the minor details. That's why it will be very interesting to see what story the media trots out in 2007 to describe the energy sector trend that is shaping up. We'll discuss the possible path that commodities could take a little later in the coming days and weeks, including in this commentary. For now we'll concentrate on the shorter-term outlook for the oil and gas stock sector as mentioned in the headline since it has been a while that we've examined at the energy sector at any length.

Some of the strongest "oversold" readings right now are coming from the natural gas stock sector. The Amex Natural Gas Index (XNG) closed on Friday at 429, near its recent 10-week low and directly atop its 200-day moving average. The 20-day price oscillator reading for the XNG on Friday came in at -44. The last two times the 20-day oscillator hit this extremely low level was on June 12, 2006 and again on October 3. In both previous instances this proved to be the low for the XNG as a bottom and recovery rally began soon afterward. There's no guaranteeing that will also be the case this time around, of course, but the odds technically favor the XNG finding support somewhere between 410-420 in the very short term and then making a relief rally attempt. This price zone is where I have the dominant short-term momentum up-wave intersecting in my wave form chart of the XNG index.

The Amex Oil Index (XOI) is also testing its 200-day moving average as of the latest close on Friday, Jan. 5. This makes the third time in the last seven months that XOI has tested or temporarily violated the rising 200-day trend line. Every previous test has seen XOI find support near it and eventually bounce higher off it to keep its uptrend intact. I think this time the XOI will find support between its 200-day and 400-day moving averages (see chart below) and will also experience a snap-back reversal, but at what cost? The fact that XOI has made this many dips to test the important interim trend line in such a compact time period is a cause for questioning the strength of the dominant interim momentum (not to be confused with the longer-term trend). With each successive drop down to the 200-day MA the XOI is losing a bit of upward momentum and this fact is seen by looking at the rate of change (momentum) readings in the number of oil stocks making new highs on a 30-day, 60-day, 90-day and even 120-day basis.

In my 2007 outlook (available to subscribers) I wrote, "Commodities will lag the stock market as leadership is passed from hard assets to paper assets. Most inflation-sensitive commodities [including oil] will remain range-bound through the first half of the year, although a test of the 2006 highs is possible. A fresh surge to record levels in 2007, however, is in question." I still believe this to be true as we step into the New Year and the deterioration in the new highs/new lows momentum is a definitely a yellow flag.

What the price of crude oil and the XOI will be at the end of 2007 I haven't a clue. But I can say that unless there is an explosive increase in the new highs among the oil equities, and fairly soon, the 120-day oil stock momentum gauge will deteriorate as we head further into the year. This in turn will keep the oil stocks from repeating their 2004-2005 performance when oil stock prices were rising in sky rocket fashion and will see a return to a more subdued market.

One analyst whose work I respect sees the 2004-2005 energy sector rally as being at least partly a product of the extremely severe hurricane trend of those two years. That's an assessment I can't help agreeing with. With the overall level of fear subsiding entering 2007 (as shown in the Global Bombing Index readings since September) this will undoubtedly take some of the "punch" away from the energy sector, which is somewhat fear-driven. In 2004-2005 the dominant internal momentum indicators as reflected in OILMO numbers (based on the net number of oil stocks making new highs) were all moving upward in harmony, which assured a powerful bull market. In recent months, however, most of these momentum measurements have rolled over and are no longer in synch with each other. That's one reason why 2006 wasn't a super powerful year for the oil and gas stocks. If you look at the long-term chart for the XOI and XNG indices you'll see that for 2006 the oil and gas stocks were mostly range-bound, albeit with an upward bias. That upward bias is courtesy of the 120-day momentum indicator which for the XOI is still in an uptrend. But even 120-day oil stock momentum is apparently topping out as you can see in the chart below.

The 90-day oil stock momentum indicator, which measures the dominant interim momentum, is also currently down but is projected to turn up again within the next couple of weeks. This should allow the oil stocks to stabilize and find support, with the XOI index presumably bottoming somewhere above the 400-day moving average and experiencing a technical rally. Whether XOI can overcome its recent high is questionable, though. Beyond the short term outlook, the intermediate term is looking very "iffy" and as mentioned in the above paragraph, if the 120-day oil stock momentum continues to erode in the next few weeks (and I believe it will), we'll have confirmation that the 2006 highs will probably not be surpassed this year and that the oil/gas stock sector will probably lag the broad market as alluded to earlier.

Clif Droke
ClifDroke.com

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving internal momentum and moving average systems, as well as securities lending trends. He is also the author of numerous books, including "How to Read Chart Patterns for Greater Profits." For more information visit www.clifdroke.com.

Copyright © 2003-2008 Clif Droke

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