Trading the Oil Bull 2

By: Adam Hamilton | Fri, Dec 17, 2004
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Last summer's boiling oil market has cooled considerably and plunged by 26% since its latest interim top. After surging from $42 in early September to over $55 on extremely bullish sentiment in late October, oil has since relentlessly retreated back to under $41 this week.

I find these big oil swings of late particularly fascinating because they so beautifully illuminate the fickle nature of short-term sentiment. While supply and demand fundamentals drive oil prices over the long term, over the short term popular speculative sentiment is vastly more influential on oil just like in any other heavily traded market.

And wherever sentiment blasts back and forth between greed and fear, excellent trading opportunities are almost sure to abound. As contrarian speculators our mission is to read the thundering herd and take the opposite position. When they are wildly bullish like near the October top, we should be throwing short. When they are growing morosely pessimistic like today, we should be getting long. One of the primary keys to short-term speculation is simply fighting the crowd.

Fighting the thundering herd is easier said than done. Since the moment we humans are old enough for our first coherent thought to rattle around in our little skulls, we naturally want to fit in. We want to be liked, we want our ideas to be accepted, and we do not want to be the lonely scorned black sheep drawing the fierce ire of all the good little white sheep.

To really drive this home, think of the overwhelming silliness of the raw energy put into being "popular" by kids in high school, either back when you were there or seeing your kids sucked into this peculiar game. The innate need to fit in is so great that teens often treat it like an 80-hour-a-week job, and they feel this quest has dire life-or-death consequences!

Contrarian speculators have to work very hard to overcome this instinctive desire for acceptance. Everything we have felt and learned all our lives about conforming and earning acceptance in our peer group has to be thrown out the window. Instead we have to actively suppress our own personal feelings while at the same time becoming hyper-sensitive to the popular feelings permeating a given market, granting us the necessary perceptiveness to fade the mainstream.

Earlier this week, all the oil news I saw, all the commentators I heard, and most of the people I talked to were very bearish. Oil was falling and an expectation was growing universal that it had to fall much lower. Contrast this with conditions back in mid-October, when even non-financial media like the big networks' evening news shows were talking about oil soon surging above $60. In October sentiment was too optimistic at the interim top, and now sentiment is probably too pessimistic at what looks to be an interim bottom. Markets always work like this.

In my original "Trading the Oil Bull" essay published in October just before the latest interim top, I tried to warn that a major correction was highly probable. Pretty much everyone at the time was ragingly short-term bullish, so the short-term bearish play was the contrarian trade of choice. When oil was approaching its mid-$50s on October 8th I wrote…

"With oil stretched more than 33% above its 200dma, the greatest divergence witnessed in years, oil looks extremely overbought technically at the moment. Remember, short-term pullbacks are normal and healthy in all bull markets! Oil has been running very strong for about a year now and positive sentiment is waxing quite extreme. Markets flow and ebb and oil seems to be about due for a temporary countertrend ebbing to bleed off these speculative excesses."

"Thus, I expect an oil correction is due sooner or later here. If you want to go long oil-related speculations, now is not the time to pull the trigger. A normal pullback would drag oil back down near its 200dma, around $39 today."

Well, 44 trading days later just this week oil did indeed cross under its 200-day moving average for the first time in over a year. Thus, just as general oil sentiment is collapsing into despair we are faced with an excellent opportunity to go long oil once again, today. This week I would like to discuss trading the oil bull once again, but from the other side of the trade, now being bullish while the mainstream grows increasingly bearish.

Our charts are updates from my original essay, clearly showing both the anticipated correction and laying out the strong case that probabilities are finally ballooning in favor of long-side oil trades yet again.

First it is useful to gain a strategic perspective to keep the short-term noise in proper context. Make no mistake, crude oil is in a long-term secular bull market. From surging Asian demand to dwindling major new oilfield discoveries, the bullish fundamentals driving this long-term oil bull are well known. I discussed them a couple months ago in my original essay if you would like a refresher. Oil is likely to trend higher for years to come in light of its extremely strong underlying fundamentals.

Nevertheless, even strong long-term primary bull markets are perpetually surging ahead and correcting back due to temporary imbalances of greed and fear. When popular sentiment gets too excited, speculators pile into oil futures and frantically bid prices higher in great temporary spikes such as early 2003's or this past summer's. Commentary gets ridiculously bullish and short-term price predictions grow laughably extreme.

Yet, extreme short-term greed never lasts and soon the inevitable selling starts, eventually breeding popular fear. Some usually trivial news catalyst sparks some initial selling at an interim top which scares others into selling. A vicious circle promptly ignites as a flood of sell orders hits the oil futures markets and a full-on countertrend correction is soon underway. Eventually when fear in oil grows too great, a sharp V-bounce occurs and its primary bull-market uptrend resumes.

While you can draw a best-fit straight line parallel with oil's secular bull, temporarily excessive greed or fear periodically forces oil prices up above or back down below this main long-term trend. This is certainly nothing mystical or particular to oil, as every market I have ever studied works the same way, driven by the same popular greed and fear. Emotionally driven herd behavior in humans never fails to be as predictable today as it was in centuries past.

Since short-term prices can be pushed and pulled all over the place even within a long-term bull, there is zero contradiction inherent in a speculator being long-term bullish while at the very same time being short-term bullish, bearish, or neutral. I continue to be amazed by the e-mails I get from folks who can't quite grasp that short-term trades in any direction can be very profitable regardless of if they are with the primary trend or counter to it.

The key to short-term speculation lies in the timing, gaming when the probabilities are highest for oil to move in one direction or the other over the next several months. A prudent contrarian speculator will only trade when the probabilities seem to be massively in his favor. He patiently waits until he finally has a high chance of winning and only then will he pull the trigger. He won't win all the time, but if he trades with probabilities he will win far more often than he loses and his capital will multiply accordingly.

For trading the oil bull, I have been applying my Relativity technical speculation theory to crude oil to attempt to discern timing. It involves comparing a price to its 200-day moving average to understand probabilities for major short-term swings in either direction. Originally designed for and heavily tested with great success in the precious-metals bulls, this tool seems to be well suited for trading the periodic flowing and ebbing within the secular oil bull.

In order to trade the oil bull, we speculators have to buy low and sell high, or vice versa. If you carefully look at the chart above, you will note that oil had the highest probability of being relatively "low", poised for a major short-term rally, only when it was near its 200dma. Bull to date you could have thrown long oil anytime it was at or below its 200dma and then watched prices march much higher in the profitable subsequent months.

Conversely, when oil diverged far above its 200dma, probabilities surged that a sharp countertrend correction was due. Speculators, contrary to popular "wisdom", want to be short when greedy sentiment drives oil too far above its 200dma. At very least a wide 200dma divergence signals a consolidation looming ahead, but far more often than not a serious correction that can decimate leveraged longs if they are not paying attention. Big 200dma divergences for oil portend poor performance in the next few months.

The average countertrend correction after major oil uplegs is running 26% bull to date. The average major uplegs preceding these periodic corrections have been running an utterly massive 58% bull to date. Thus speculators playing oil directly via futures or options have all kinds of opportunities to earn great profits by actively trading this oil bull. Contrarian speculation can be fantastically lucrative for those who can train themselves to fight the crowd.

Before we get into the latest precisely quantified 200dma divergence data for crude oil, there is one more technical point I would like to draw your attention to on the graph above. It is possible, not certain, that the slope of oil's bull market is increasing. For the past 15 months or so oil has carved a steeper new uptrend, framed in light blue above. We already have multiple support and resistance intercepts so this new channel seems strong and there is a distinct and growing possibility that it may hold into the future.

This week oil bounced off this new steeper support line, just under its 200dma which also forms major secular-bull support for prices. With oil bouncing off its latest linear support as well as its 200dma, I suspect we have an excellent probability here that oil is not heading significantly lower. Odds are it will consolidate for a few months such as it did in mid-2002 and mid-2003 before heading higher again in a glorious new bull-market upleg.

Our latest Relative Oil, or rOil, chart precisely quantifies the degree of divergence between oil and its crucial 200-day moving average. It is simply calculated by dividing the oil price by its 200dma. This results in a ratio that expresses oil as a constant multiple of its 200dma, granting us speculators a well-defined trading channel to use to identify high-probability moments when oil is technically too dear and due to fall or too cheap and due to rally.

The rOil numbers are graphed on the left axis, and speculators should think of oil's usual relative range as a probabilistic trading channel. When rOil exceeds 1.25, or oil is at 125%+ of its 200dma, then odds are the next major move in oil will be lower. For a lot of sentiment and mathematical reasons markets just don't like staying diverged far away from their 200dmas for long. They always want to revert back to their 200dmas periodically after a wide diversion before resuming their primary trend.

On the low side of this relative channel, once rOil trades under 0.95, or oil slumps to 95% or less of its 200dma, odds are the next major move will either be a major rally or at least a sideways consolidation gradually angling higher. So far speculators have been well rewarded for throwing long oil-related plays whenever oil falls down near or under its 200dma. With last Friday's rOil close of 0.955, we are once again in this high-probability-for-long-success sweet spot today.

This very analysis led to my warning of an imminent oil correction in the original "Trading the Oil Bull" essay in early October. As a mere mortal I certainly cannot see the future, but as a speculator I can choose to trade only when probabilities are heavily in my favor and not trade when they are either ambiguous or against me. There is no sense speculating unless the odds of winning are high.

Relative oil ranges are probabilistic because there is really no certain point when one should absolutely be long or absolutely be short. We currently use a somewhat arbitrary range running from 0.95 to 1.25 as a guide, but in reality the probabilities are not discrete but continuous. The farther above its 200dma that oil stretches during a particularly euphoric upleg, the higher the probability that a sharp correction is coming. Conversely the lower that oil falls relative to its 200dma during a correction, the greater the probability that a major rally is approaching.

This analysis is also heavily dependent on this secular oil bull remaining in force for fundamental supply-and-demand reasons. When the secular oil bull ends, this trending-market trading model will fail at that transition. Nevertheless until that fateful day somewhere off in the future arrives, trading oil relative to its 200dma should continue to be quite profitable.

All you have to do to successfully trade this awesome secular oil bull over a multi-month time horizon is to expect oil to flow and ebb away from and back to its 200dma, like all other bulls in history. Be long when oil converges with its 200dma and be short while it reaches divergent extremes above its 200dma. This is an extremely simple concept, but remarkably effective in practice due to the mathematical nature of 200dmas and the inevitable greed/fear psychology pendulum perpetually swinging through short-term markets.

With oil once again near its 200dma and a strong relative buy signal today, probabilities are high that long-side trades launched now with multi-month time horizons will prove quite profitable later in 2005. We probably won't head straight up though, for a couple reasons. First, after a major correction leveraged long speculators are heavily wounded and it takes a while to rebuild their confidence in and appetite for risky long-side plays.

Second, following the first two major uplegs labeled above, crude oil tended to consolidate for a couple quarters or so. If oil continues to follow this recent historical precedent today, it may flatten out for awhile to build a new base for its next assault on fresh new bull-to-date highs. And higher highs still ought to be coming. In inflation-adjusted terms the $60+ oil we are likely to see at the next major interim top really isn't terribly extreme by historical standards. Back in 1980 oil handily exceeded $90 in today's inflation-ravaged dollars.

Thus, I think we have a good chance of a consolidation here before the next major upleg in oil. This possibility is very important for speculators to consider, especially ones trafficking in derivatives. If oil proves true to recent historical form and reconnoiters for awhile before assaulting new highs, short-dated call options may expire worthless before the fourth major oil upleg really gets underway in earnest.

For long-term investors, these periodic 200dma reversions are the ideal time to deploy capital in oil-related stocks. I like looking for oil stocks that are sound enough to be long-term investments but that still leverage oil well at six-month time horizons. At Zeal we have been investigating all kinds of oil stocks looking for good opportunities for this very moment, but so far our search hasn't yielded much fruit. Oil stocks, for the most part, are just not providing great leverage to oil so far.

Equity investors willingly bear big risks, so we expect returns exceeding those available in the underlying commodity. In the case of oil stocks, they have been largely lethargic from a tactical perspective. While gold stocks have often leveraged the gains of gold in its major uplegs by 4x to 5x+, producing blue-chip oil stocks are unlikely to even double the percentage gain in oil.

With capital scarce, it is hard to buy oil stocks hoping for a 20% gain in the next six months or a double in a few years when the very same capital could be deployed into gold stocks with reasonable expectations of 50%+ gains in six months and hundreds of percent in the coming years. This being said, the low volatility oil stocks are vastly less risky than gold stocks in general, so risk has to be considered with the potential rewards. Oil stocks also often have respectable dividends while those of metals stocks are usually trivial or nonexistent.

But until more pure speculators enter oil stocks in earnest and start aggressively moving their prices around with oil, oil stocks aren't quite as attractive as other purer commodities plays like gold and silver stocks. Like it or not, the opportunity cost of investing in oil stocks so far, as compared to other primary commodity producing companies, has been quite high.

Nevertheless, we are continuing our painstaking oil-stock search and will definitely recommend purchase to our newsletter subscribers of promising oil stocks when we come across them to take advantage of this excellent long opportunity. If this rOil concept interests you, our Zeal Intelligence subscribers also gain access to a large Relative Oil chart updated weekly on our website so you can follow these trading signals and probabilities yourself.

The bottom line is oil sentiment was far too bullish in October while it was topping and it is growing far too bearish today while it is likely bottoming. As long as the core supply and demand fundamentals driving this secular oil bull remain intact, 200dma convergences are the best opportunities available to throw long for both short-term speculators and long-term investors.

In order to throw long though, you have to think like a black-sheep contrarian and ignore the growing negativity permeating mainstream oil analysis. Instead you have to fight the crowd and make the very trade that conventional wisdom considers foolish since the vast majority of players now believe oil is going lower, not higher.


 

Adam Hamilton

Author: Adam Hamilton

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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