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October 08, 2004

Trading the Oil Bull
by Adam Hamilton

Whether you traffic in the circles of belligerent contrarian thought or the mainstream market consciousness, chances are today's surging crude oil market is among the most popular topics of financial conversations in your world these days.

The spectacular oil market of late has transcended the usual market boundaries and captivated the attention of everyone. It is not only the hardcore commodities bull crowd that is paying attention these days, as even the tech-stock-worshipping cult of CNBC seems to be migrating to an all-oil-all-the-time focus. Such a massive paradigm shift would have been inconceivable in 1999!

This growing popular fascination (or horror) surrounding the spiking crude oil prices is easy to understand. In this modern Information Age world totally dependent on transporting vast numbers of people and goods around the globe each day, the oil price really does have a ubiquitous impact. Any time that any physical thing is moved from one location to another, energy costs are a factor. And oil utterly dominates today's energy scene, with rising oil prices adding higher transportation costs to everything else.

As investors and speculators, the amazing oil action in the past year or so presents great opportunities as well as great risks. When markets are moving as rapidly as oil, exhibiting broad volatility profiles that provide many points to buy low and sell high, fortunes can be won. At the same time though, the longer a market is strong and the more people that become aware of it, the riskier it becomes as entry prices march higher.

Like practically everyone else in the financial realms, I have been pondering oil a lot in the last year. I have written on oil indirectly as a key component of the general commodities bull and also from the perspective of oil's relationship with gold, but not as a primary topic of discussion. Thus, this week, I would like to examine the ongoing crude oil bull market, focusing on its potential to be actively traded moving forward.

To start, it is important to consider the spectacular oil price action of recent months in context. Our first chart fleshes out the trend lines dominating this oil bull and offers many insights into its strength and potential staying power.

When examining any trend, it is important to consider the length of time that it has been in force. The longer a given trend has run, the more powerful the underlying fundamental forces driving it. And the more powerful the underlying fundamentals, the less likely the trend will end prematurely before these driving fundamental forces fully run their course somewhere out in the future. In oil's case its uptrend is immensely strong.

The uptrend shown on this chart is very well defined since oil's interim low near $17 in November 2001. The support line drawn above is rock solid with its several major intercepts over multiple years. The parallel top resistance line is not quite as well defined with oil breaking above it in early 2003 and today. When an uptrend of this considerable length is combined with oil's periodic forays into the blue sky over its primary resistance, it is evident that this oil bull is very powerful and chomping at the bit to gallop higher.

It is interesting that this particular trend in this chart is on the verge of going secular. A secular market is a major long-term bull or bear that runs for at least three years. Not too long after Americans head to the polls to choose our next fearless leader, this oil trend will have officially entered the fabled annals of seculardom. And with oil's lower support line now running way back near $34 or so, it is almost inconceivable that oil could fall far enough in the next six weeks, when this uptrend turns three years old, to knock it below support.

Of course all you oil speculators who weren't totally distracted and brainwashed by the NASDAQ bubble remember that $17 crude in November 2001 certainly was not the beginning of this oil bull. The secular oil bear which began in 1980 really ended in December 1998, around $11 per barrel. I remember paying less than $1 per gallon at the pump for gasoline in late 1998, an absurdly low price that made gas cheaper than the gallon jugs of drinking water sold at the same gas stations!

So, from a proper and true reckoning, our current oil bull began in December 1998, not November 2001. That makes it nearly six years old today, double the minimum standard to declare a primary uptrend a secular bull. Therefore there is zero doubt that oil is in a secular bull today, a mighty primary trend that will power forward, unstoppable, until the core fundamental supply and demand imbalances driving it are finally brought into sync at some undefined point in the future. Betting with a fundamentally-driven primary trend is one of the wisest and lowest-risk plays in all of investing.

Just what are these unstoppable fundamental forces driving this secular oil bull? On the demand side, it is you and me!

Our whole modern way of life is heavily dependent on oil. We Americans consume more of it per capita than anyone else on earth. We are blessed with a big country in which we can freely drive anywhere for any reason, and many of us live far from our work and spend an hour or more commuting, burning oil, each day. Everything physical we buy, all our goods, is also transported to us in oil-burning vehicles. Oil demand is not going down unless the whole economic paradigm undergirding modern civilization somehow crumbles.

The European nations burn a lot of oil too, for the same reasons as us Americans, but not as much per capita. The US and most of Europe import vast amounts of oil every day to move people and goods to where they need to go. And the Americans and Europeans really don't seem too price sensitive to oil. Whether gasoline is $1 or $10 a gallon, people still need to get to work, buy groceries, go out and play, etc. I suspect it would take oil prices far higher than anything ever witnessed to really get us to seriously change our oil consumption patterns.

American and European oil consumption has been high for decades, so the big fundamental wildcard is really the mushrooming industrialization in Asia, especially the twin behemoths of China and India. With a combined population approaching 2.4b people or so, these two countries alone have the potential to eventually consume as much or more oil than the States and Europe put together. As the Chinese, Indians, and other Asians in industrializing nations experience the countless joys and conveniences of living in a modern petroleum-based civilization, their thirst for oil will only multiply.

This insatiable rising global demand for crude oil, with the greatest marginal growth coming out of Asia, is one of the powerful fundamental forces undergirding this secular oil bull. If you want to bet that global oil demand is going to drop, then you have to bet that Americans and Europeans will dramatically curtail their driving and/or the billions of people in Asia will suddenly cease their vast industrialization campaign. These sure don't sound like prudent bets to me!

This rising demand simply cannot be met with existing world supplies of crude oil. Unlike most industries, natural-resource businesses cannot just boost production at will to meet rising demand. Finding and extracting oil takes huge amounts of capital and lots of time. And since the 1950s much of the planet has already been scoured for oil, reducing the probabilities that large future deposits will be found without some great leap forward in extraction technology.

And while large new supplies are seldom, if ever, being discovered these days, existing reserves are drying up. In the last year several major global oil players actually had to revise their oil reserve estimates downwards. And if the biggest and best companies, with the brightest minds and unlimited capital, are having trouble growing their reserves then new oil reachable by current technology is just not out there.

World production also seems to be nearing its Hubbert Peak, its point of maximum production. The brilliant geologist Dr. Marion King Hubbert defined this theory in the 1950s, which has proven to be uncannily accurate in the last half century. He stated that with any finite resource, like an oilfield, production starts at zero, it then rises to a peak which can never be surpassed, and then it declines until the resource is depleted. This simple, yet powerful, logic also applies to all the existing oilfields collectively, the world as a whole.

Most existing major oilfields now producing on the planet, including many in the Middle East, are either past or near their Hubbert Curve Peak. They have been pumping for decades and it is getting harder and harder to extract oil. Production at individual wells within many of these fields has already started declining. Eventually it will cost so much to wring oil out of these tired old fields that they will become uneconomical and be abandoned. Any given oilfield taps a finite pool of the black stuff that can eventually be depleted after enough is extracted.

Thus our current secular oil bull is being driven by relentlessly rising oil demand worldwide coupled with global oil supplies that, while not yet shrinking, simply cannot be grown fast enough to keep up with demand. In any long-term situation where free-market demand exceeds free-market supply, the only possible market solution is for a rise in price. As oil gets scarcer relative to those who want to buy it, its price is bid up so the oil is effectively allocated to those who value it the most. These ironclad supply and demand laws can never be broken over the long-term.

When the secular technical uptrend of oil is viewed in light of its immensely bullish supply-and-demand fundamentals, odds are this bull market has years to run yet. Oil prices have to eventually meander high enough, for long enough, to retard global consumption to bring supply and demand back into line. Today's $50ish oil, far below the all-time real highs above $90 a barrel in 2004 dollars back in 1980, is probably nowhere close to being high enough to radically alter ingrained global consumption patterns.

As the chart above makes crystal clear though, just because a primary trend is bullish does not mean that there won't be periodic pullbacks. Both oil investors and speculators want to buy oil-related plays low, during corrections. Investors will then hold for many years while speculators will sell at the periodic oil peaks. As gold has abundantly demonstrated in recent years, periodic pullbacks are healthy and par for the course in a secular bull.

The flowing and ebbing nature of this oil bull is readily apparent. The percentage numbers on the horizontal axis above show oil's annual gains, year-to-date in 2004's case. Oil has been alternating massive up years with flat or down years. Like all secular bull markets, it has advanced two steps before retreating one. This typical behavior is normal and expected and provides outstanding trading opportunities for speculators.

In fact, today's sharp oil spike looks remarkably like two of the previous greatest oil trading opportunities in the last few years. There are three major uplegs numbered above, along with their subsequent pullbacks. If you compare rallies 1, 2, and 3 visually, it is apparent that their steep upslopes were rather similar. In all three cases crude oil advanced sharply, usually surging to fresh new bull-to-date highs. But in the first two cases, oil soon retreated in a pullback as general sentiment waxed too euphoric near the interim tops. Will we see a similar healthy pullback soon in the breathtaking rally 3 today?

To analyze the possibilities of such a correction, we prepared a new crude oil graph based on the principles of technical Relativity I discussed last week. Relativity compares a price to its 200-day moving average. Bull markets tend to advance and diverge from their 200dmas before retreating and converging, the typical two-steps-forward-one-step-back bull-market profile. Per this theory, the best time to go long oil-related investments or speculations is when oil trades near its 200dma, when Relative Oil, or rOil, is low. Conversely speculators probably want to be short or at least neutral when rOil gets too high.

Our final chart graphs this rOil construct, oil divided by its 200dma, on the left axis. Oil and its key moving averages and Bollinger Bands are graphed on the right. This reveals some intriguing trading zones of interest not apparent in the conventional chart above.

Since 2002, which gives us an ideal slice of time of nearly three years in which to consider Relative Oil ranges, rOil has been amazingly consistent in reversing soon after oil trades more than 25% above its 200dma. Twice in 2002, once in 2003, and twice so far this year, oil has witnessed sharp pullbacks not long after rOil stretches above 1.25 or so. This suggests that investors and speculators do not have high odds of success if they throw long oil when it is already trading so far above its 200dma.

On the low side, marked by the green zone and numbers, rOil is not as consistent in carving major interim bottoms. Oil has bounced higher when rOil was anywhere between 0.84 and 1.04, really a broad range. Nevertheless, this relative comparison does show consistency in that oil was always an optimum tactical buy only when it was near or under its 200dma, and never when it was far above.

If we apply the core Relativity precepts I described last week to crude oil, a model for actively trading this secular bull market in oil emerges. Both investors and speculators want to go long oil-related vehicles when rOil is low and speculators want to sell and/or throw short when rOil gets too high. In order to define an actual trading range of interest, we need to consider two to three years of data, shown above, and define relativity zones with multiple intercepts.

The top side, the short or sell zone, is amazingly well-defined in crude oil's case. Out of the hundreds of Relativity charts I have built and analyzed, this one really strikes me as extraordinarily consistent. In the past few years oil never retreated significantly when it was less than 25% above its 200dma, but once it exceeded this 25% threshold it pulled back soon after, almost without fail. So we are currently defining an rOil level of greater than 1.25, which has no less than 5 historical intercepts, as our short zone. This is shaded in red above.

The green buy zone on the bottom is not as clear, but going long oil-related plays when rOil is less than 0.95 or so seems a happy medium based on the data. This 0.95 line has multiple intercepts in 2003, not to mention a near intercept in 2002. In addition, it more or less splits the recent relative bottoming range of crude running from 0.84 to 1.04. Thus, this chart suggests investors and speculators want to be long crude for another major upleg whenever it trades around 95% or so of its 200dma.

This Relativity perspective on crude helps us define a range of interest of when crude is relatively undervalued technically, the time to buy, or relatively overvalued technically, the time to sell. We ought to consider going long when crude is at 95% of its primary 200dma support, and going neutral or outright shorting when crude trades more than 125% above its 200dma support.

And please remember that Relativity is more of an analog probability range than a strict binary buy or sell signal. As long as oil's secular bull remains intact, the higher up that rOil is stretched in a major upleg the greater the probability that a correction is imminent. Conversely the lower that rOil is pummeled in a correction, the greater the probability that a major oil upleg is just over the horizon. Probabilities, not absolutes, govern the markets.

This relative trading model, while simple, would have been quite profitable in recent years. And if oil's secular bull market in oil continues, as the fundamentals virtually assure, then this trading model will probably be useful and profitable going forward as well. Rather than just guessing when crude is low enough to buy or high enough to sell, the hard Relative Oil numbers provide an empirically precise way to quantify this over time.

And we certainly must not overlook the message of rOil today. 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. While the technical pullback will probably happen regardless of news, I suspect some news will be found to "justify" the pullback.

One intriguing contender for this "justifying" news is the possibility that Washington will release Strategic Petroleum Reserve oil in the weeks ahead to attempt to lower oil prices ahead of the US presidential elections. Regardless of the reasons ascribed after the fact though, oil just looks plain short-term overbought and due for one of its periodic bull-market corrections. No excuse is necessary, though the media will certainly find one.

If you are interested in monitoring this fascinating ongoing oil bull, and in trading it, we are now tracking and analyzing Relative Oil in our acclaimed monthly Zeal Intelligence newsletter for our subscribers. We are also hard at work looking at various leveraged oil-stock contenders for potential recommendation and purchase next time oil retreats and triggers an rOil buy signal. As gold has proved abundantly, periodic retreats in secular bulls offer stellar buying opportunities. Please join us today!

With global oil demand relentlessly rising while global oil supplies look flat to declining as far as the eye can see, odds are this secular oil bull is nowhere close to giving up its ghost yet. Nevertheless, even the most powerful of long-term bulls have periodic corrections to bleed off short-term sentiment imbalances. The Relative Oil indicator suggests that just such a pullback is probably due soon here in crude oil.

Since these periodic short-term pullbacks often mark the greatest buying opportunities available in long-term bull markets, investors and speculators should really watch rOil closely in the weeks ahead, especially if this probable technical retreat does indeed materialize.

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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