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May 26, 2007

Good Oil Bad Oil?
by Greg Silberman

Article originally submitted to subscribers on 21st May 2007...

It took me by surprise!

I noticed the Amex Oil Index recently broke out to fresh highs after moving above a 1½ year congestion zone.

The first thing I wondered was - what does this meant for the price of Oil? Will it re-challenge its July '06 highs of $79? And what would that mean for the stock market?

It's worth noting the relationship between Oil and the Oil stocks is not as clean as Gold and Gold stocks.

Gold Stocks lead and the metal follows soon after in the same direction. Not so with Oil.

Oil Stocks can diverge from the price of Oil for long periods of time, as can be seen below when Oil Stocks moved higher between 1992 and 1998 whilst the price of Crude hovered around $20/barrel.The reason, Oil Stocks behave like regular stocks in that they benefit from an increase in growth expectations, quite independent from movements in the price of Oil.

Chart 1 - Oil Index looking overbought; Crude Oil (top)

Even though it recently broke to fresh highs, the Amex oil Index is currently over-extended:

The index is nearly 40% above its 200 day moving average;
The RSI is above 70 in over-bought territory;
Based on my Fibonacci work, the current wave that began at 406 is very close to completion at 1400.

Compare that with Crude (top) which is only about 20% above it 200 day moving average and the internal indicators (not shown) are not overbought.

So does a fresh break to new highs in Oil Stocks mean Crude is about to bust out?

Maybe!

Due to the extreme divergences that can exist between Oil Stocks and Oil, we cannot necessarily assume Crude will move higher just because the Oil Stocks have.

But here's an indication that it might:

Chart 2 - Gasoline vs. Crude Oil (behind)

Gasoline Prices have been on a tear lately.
The main reason is bottle necks at refineries.
But take into account that we are fast approaching driving season, hurricane season, and never-ending geopolitical strife in the Middle East; one can be forgiven for thinking the price of Gasoline will be heading much higher.

A move above $2.50 would clinch it from a technical point of view. Projecting a target of $3.70. That may very well mean gas at the pump of $5 in some areas. Ouch!!

Based on the close correlation between Gasoline and Crude, a breakout in gasoline would surely be followed by a breakout in Crude!

And that brings us to the stock market. What does a breakout in Crude prices mean for the stock market?

Chart 3 - Oil Stocks : Crude Oil ratio; S&P (below)

During periods when Oil Stocks outperform Crude Oil, the stock market is usually bullish (the above chart is rising). When Oil outperforms the Oil stocks, the stock market does poorly as can be seen between 2000 and 2002. In other words, rising Oil is not necessarily bad for the stock market as long as Oil stocks are rising.

Current Interpretation: The AMEX Oil Index in Chart 1 looks very over extended technically whilst Crude Oil in Chart 2 looks like it may be setting up for a run to its previous highs. Under such conditions the Oil Stock: Crude Oil ratio would decline which as mentioned above is not good for the stock market.

$5 Gas may very well be the consumers' nemesis. The point where the consumer retrenches and reigns in spending. At least that's what the market is telling us!

Implications for Gold: A rising Oil price and a falling Stock Market would be a heady cocktail for investors. Inflation would be undeniable and the prospect of money printing to stem a falling market would be huge. Gold has a promising future indeed!

More commentary and stock picks follow for subscribers...

Greg Silberman CA(SA), CFA
www.goldandoilstocks.com

Profession: Research Analyst and Newsletter Editor
Company: Ritterband Investment Management LLC

Career Brief: Greg qualified as the youngest Chartered Accountant and Chartered Financial Analyst (CFA) in South Africa in 1998 at 25 years old. After completing his traineeship with Grant Thornton he moved to London where he worked for JP Morgan Chase in their Fixed Income Swaps Division. Sick of the grey skies and cold weather Greg relocated to Atlanta, Georgia where he spent the next 4 years freelancing as a management consultant. His targeted clients were fast growing mid size US based companies and he worked across many industries including credit cards, health insurance and energy trading. Greg has recently returned from Sydney Australia where he spent the last 2½ years working in Equity Derivative Structuring for Perpetual investments a major Australian Asset Management Company.

Greg has a passion for the markets and has been writing Greg's market newsletter for 2-years. A newsletter focused on metal and energy stocks and recently non-resource small caps listed in the US and Internationally.

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.