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Trading the Oil Bull

Adam Hamilton

October 8, 2004


While crude oil is in a secular bull market, periodic pullbacks to bleed off sentiment imbalances should be expected. Relative Oil suggests one is coming.

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
October 8, 2004


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Trading the Oil Bull 2

Adam Hamilton

December 17, 2004

3002
The sharp slide in crude oil in the last six weeks or so has led to an explosion of bearishness. Yet, oil is now looking like a great technical buy again.

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, CPA

December 17, 2004
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XOI and SPX Correlation

Adam Hamilton

June 10, 2005

2965
Oil stocks have had a high correlation with the general stock markets in the past few years. This has important implications for oil-stock investors.

With oil prices besting $50 per barrel almost continuously since late February, investors and speculators are definitely taking notice. Oil stocks are finding their way into more and more portfolios.

Contrarian investors usually see oil stocks as a great way to ride the secular commodities bull now unfolding. Oil is in huge and growing demand worldwide, large new fields remain extremely elusive, and not much oil is stockpiled relative to global demand. This is a perfect long-term environment for the stocks of elite producers to thrive.

Mainstream investors, not yet too convinced on this secular commodities bull thesis, are increasingly buying oil stocks anyway to diversify their portfolios. Commodities are well known as countercyclical plays, they tend to do well when the general markets are struggling. Owning oil stocks is believed to lower overall portfolio risk.

Portfolio risk is reduced if not all the stocks in one’s portfolio tend to do the same things at the same times. If you own both Intel and Microsoft, for example, a slowdown in personal computer demand would hurt both companies at the same time. But if you own Intel and Exxon Mobil, the PC slump would only affect Intel. Tech-stock fundamentals and oil-stock fundamentals are not interrelated at a micro level so diversification mitigates individual-sector risk.

This type of portfolio diversification is helping drive oil-stock demand among mainstream investors. But what if this core premise, that the general markets and oil stocks are not correlated, is no longer true? What if oil stocks now tend to move in lockstep with techs, financials, and other popular market sectors?

If it indeed exists, the implications of a growing correlation between oil stocks and the general markets are serious for both contrarians and mainstreamers.

Contrarians generally assume that commodities plays are largely immune from general-market slumps, and they have been more or less right so far. Most commodities plays, like gold stocks for example, are so lightly held by mainstreamers that they don’t correlate with the general markets. Mainstreamers can sell all they want but since they don’t own these commodities stocks general selling pressure shouldn’t hit them.

But if enough mainstream capital is entering oil stocks, then they are at the mercy of mainstreamer whims. If oil stocks are widely held then mainstreamers may very well panic and dump them whenever general stocks slide. A little fear in one part of a portfolio can ignite selling all throughout it even in unaffected sectors, as frightened investors tend to throw out the baby with the bathwater. Thus oil stocks could get hammered in a general stock-market selloff, not a happy thought for contrarian investors owning these companies.

The mainstreamers face problems of their own. If oil stocks and the general markets are becoming correlated, then oil stocks’ usefulness as countercyclical plays to reduce overall portfolio risk wanes dramatically. If an oil stock mirrors a tech stock, then there is no portfolio advantage gained from owning it, at least in the pure risk department.

I have always been a contrarian so I identify with the former concerns more than the latter. For six months now we have been looking to start an oil-stock speculation campaign at Zeal but so far oil has denied us an entry point. Complicating oil’s persistent strength (we only buy on weakness), complacency is so stellar in the general markets that the probabilities of a major stock selloff grow with each passing day.

But if oil stocks are becoming correlated with general stocks, then we risk getting hammered in them when the stock markets sell off. If mainstream fear leads investors to sell oil stocks because the markets as a whole are weak, then the baby-with-the-bathwater scenario happens. If this is the case the best time to buy these increasingly mainstream oil stocks will be when the general stock markets are nearing an oversold bounce on widespread popular fear.

In order to investigate the correlation between oil stocks and the general markets, this week we ran some correlation analyses between the Amex Oil Index (XOI) and the broad S&P 500 (SPX). The XOI has been around for over two decades and is designed to track widely-held corporations involved in the exploration, development, and production of petroleum. It currently has 13 component companies, most of which are the usual-suspect major oil names.

If the XOI and SPX do indeed sport a high positive correlation, then oil stocks are not particularly useful for mainstream portfolio diversification and contrarians risk getting beaten up in them in a general market selloff. Our two charts below model these correlations over various periods of time. This analysis follows the same modus operandi I used while analyzing HUI gold-stock index and SPX correlations back in April if you would like some more background on this approach.



Overall since 2000, the XOI and SPX have not been very correlated at all with a 0.21 correlation coefficient. This is good news for oil stock investors, because neither contrarians nor mainstreamers really want oil stocks to roll with the general markets for different reasons. The r-square value of this relationship really drives home this point.

Correlation coefficients are not really useful until they are multiplied by themselves, yielding a product the statisticians call r-square. This number expresses how predictable one data series is likely to be based on movements in the other. At a 0.21 correlation, overall since 2000 the oil stocks and general stocks have only had a 4% r-square. This suggests they move independently over this time horizon so neither one can predict the other.

But when we zoom in, this long-term correlation grows considerably. The chart above is divided into various sections marking major moves in the XOI. The XOI gains during these individual periods are noted in blue while the S&P 500 moves over the same periods of time are shown in red. The yellow numbers up high reveal the XOI and SPX correlations of daily closing data over each individual slice of time.

If all these period correlations are averaged, the result is 0.59. This yields an r-square of 35%. Thus, on average, major moves in the XOI considered as discrete runs have been 35% explainable by the daily activity of the S&P 500. Thankfully this is still not high at all, as prices can either go up or down and with any r-square under 50% we may as well be flipping coins to define a useable trading relationship.

So far so good, the oil stocks and general stocks aren’t highly correlated since 2000 on a whole basis or on an individual-major-move-average basis. Unfortunately though as we dig deeper and limit our search to recent years, the correlations balloon rather dramatically.

Starting in early 2002, the most vicious selloff of the secular bear plunged off the charts. Unfortunately oil stocks, which had been holding pretty stable since the bubble top in 2000, were caught up in the intense selloff. By early 2003 the S&P 500 was down an amazing 28% and the XOI was running in parity with a 29% loss. During this time of the most intense fear and panic witnessed since 1998 or 1987, the XOI and SPX correlation ran 0.89, very high.

A 0.89 correlation in this wicked downleg yields a high r-square too, 79%. Nearly 80% of these daily moves in the XOI were explainable by the machinations of the SPX. And this steep slide in the oil stocks cannot be explained by crude. Over this exact time period, early April 2002 to February 2003, oil rose 29% to $36 per barrel! The only explanation, like it or not, was mainstream investors dumped oil stocks just because they were scared by the plummeting general stock markets.

Now taken in isolation we could write this off as an anomaly, but it isn’t isolated unfortunately. Back in 2001 in another wicked general-stock downleg the XOI fell 23% while the SPX slid 22%. Once again it looks like general-market action was acting as a direct driver for the ever-more-widely-held oil stocks. When the next serious selloff in the stock markets ensues will oil stocks fare any better?

Lately it is not just the fear-laden downlegs that witness oil stocks mirroring the general markets. Since the war rally cyclical bull in the stock markets erupted in early 2003, the XOI correlation with the SPX has actually increased dramatically. Drawn above, the three major oil stock moves since early 2003 have run correlations of 0.91, 0.96, and 0.74. The 0.90+ ones are very high by market standards.

At a 0.90 correlation, 81% of the daily moves in one data series are statistically explainable by the other. At 0.96, the highest correlation in this chart that incidentally ran a rather long time at three quarters, the r-square soars to 92%! Over this extraordinary move, trading the XOI was essentially trading the far larger SPX, although the XOI’s 23% gain handily trounced that of the SPX at 16%.

Clearly the oil-stock and general-stock-market correlation is growing in recent years. Will it continue to be strong? Is it just a coincidence that oil stocks and the general markets have been in similar bull markets since 2003? Will these high correlations hold when general stocks inevitably sell off on widespread greed and complacency?

These are very important questions to consider for everyone who owns oil stocks, whether you classify yourself as a contrarian or mainstreamer. I certainly can’t see the future and don’t know the answers myself, but perhaps zooming in to just the period since 2003 can help us better handicap the probabilities at least. Are oil stocks likely to mirror any major selloff in the S&P 500 or not?



Since 2003 the total daily correlation of the XOI and SPX has run 0.86. Interestingly the average of the three major moves in the XOI over this time period was 0.87. These correlation coefficients yield r-square values hovering near 75%. So for nearly two and a half years now 75% of the daily moves in the XOI are statistically explainable by the daily moves in the S&P 500.

This is really a high correlation for a single sector and the entire broad markets, especially over such a long period of time. I haven’t done the research yet, but I suspect that this oil-stock correlation data is not much more loosely tied to the SPX than other major sectors. For example, if we ran correlation studies on tech stocks and the SPX or financial stocks and the SPX, their correlations might not be that much higher than the oil stocks.

These strong relationships are even readily apparent visually on the charts. In mid-2003 oil stocks peaked just slightly before the general stocks peaked, and after these congruent peaks both the XOI and SPX ground lower in unison for half a quarter or so. Soon their uptrends resumed in parallel and both even broke above their individual uptrends simultaneously in late 2003.

In early 2004 both topped at the same time but the XOI actually managed to decouple from the SPX for a couple quarters leading up to the US presidential elections. But even during this rare time of crossing trends the XOI still had a fairly high correlation with the SPX of 0.74 on a daily basis. It rose when the SPX rose and fell when the SPX fell in general, although by different amounts. The XOI didn’t mirror the initial surge in the election rally late last year but it did catch up with a vengeance in early 2005.

Once again though the XOI and SPX topped at the same time in Q1 of this year and both have generally been drifting lower since. The SPX broke out of its latest downtrend before the XOI’s attempt but the visual relationship between the two remains one of congruence. It will be interesting to see just how this particular XOI and SPX move plays out in the months ahead.

Unfortunately, at least if you are bearish on the general stock markets, there is no escaping the conclusion that the XOI has had a high positive correlation with the SPX in recent years, both in steep bear market downlegs and exhilarating bull-market uplegs.

This suggests that the probabilities are high that this relationship will continue without the absence of some major catalyst to alter it. For better or for worse, oil stocks are tending to follow the general stock markets.

I suspect this is because big Wall Street money is increasingly diversifying into oil stocks. Oil is gradually becoming more accepted as an investment and it is really going mainstream. On CNBC and Bloomberg stories on oil and energy stocks are becoming more and more prevalent. These days CNBC often even puts the oil price in their lower right market graphic that is usually reserved for the major stock indices.

The more mainstream capital that floods into any sector, the more its price action begins to mirror the markets as a whole. Oil stocks are no longer an obscure realm largely owned by contrarians as they were in the late 1990s when oil prices fell to dismal sub-$15 lows. Today ordinary investors are sending retirement capital to normal mutual funds where the managers are gradually adding positions in oil stocks.

And when these ordinary investors or even fund managers get scared, which always happens when the general stock markets are falling, capital is pulled out of the markets and out of these funds. I suspect the funds try to maintain sector balance when investors want their capital back, so they probably sell equal proportions of all their sectors which include their oil-stock holdings. Hence oil stocks fall with the markets.

This dynamic exists anywhere a sector becomes mainstream, but interestingly not all commodities sectors yet have. Gold stocks, for instance, are nowhere close to being an accepted investment. They remain the realm of contrarians today, scorned by mainstreamers. And contrarians for the most part are largely immune to being emotionally pressured by the big moves in the general stock markets. Sharp SPX slides don’t scare them into selling and big SPX rallies don’t seduce them into buying.

Because gold stocks are still dominated by contrarians and not mainstream capital, their correlation with the general markets is low as I analyzed seven weeks ago. And odds are these correlations get even smaller with more obscure commodities sectors. A silver or uranium producer probably has a lower correlation with the SPX than gold stocks since these commodities are even farther from the mainstream consciousness than gold.

So what’s an investor to do?

If you are a mainstream investor or portfolio manager, realize that oil stocks aren’t doing much to reduce portfolio risk at the moment. In fact, since they have been moving in such high correlations to the general markets, they probably raise portfolio risk. If you want inversely-correlated stocks to reduce portfolio risk you have to go to producers of other less mainstream commodities than oil.

If you are a contrarian investor like me, it is crucial to realize that oil stocks have a high chance of getting battered in a general-market selloff. This certainly does not mean that we shouldn’t look for opportunities to buy oil stocks, as they are likely to be fantastic investments in the coming decade. But it does have big implications for our timing decisions for entering new long trades.

In light of this analysis the best time to buy oil stocks probably hinges on two factors, the relative price of oil and the relative dearness or cheapness of general stocks.

Like any commodities producers, the best time to buy oil stocks is when the oil price is relatively cheap and oversold. This can be discerned by using various technical tools including Relative Oil. Whenever oil is slumping its negativity bleeds into oil stocks and investors get concerned and sell them. And of course the heavily anti-commodities mainstream financial media jumps on any oil weakness and heralds it as the end of the oil bull. This negative coverage spreads fears hurting oil stocks temporarily, a great time to buy.

But since the XOI and SPX move like intertwined dancers, a second factor needs to converge with lower oil prices. The general stock markets should be oversold, not overbought like today. This can be measured by a variety of tools including Relativity, implied volatility indices, and various other sentiment gauges. The most superb opportunities to throw long oil stocks in a big way should occur when both lower oil prices and lower SPX prices converge.

While we haven’t seen such a convergence recently we sure could later this year. At Zeal we are ready to roll with a new oil-stock trading campaign as soon as these two oil-stock stars line up. When the ideal conditions finally arrive we will pull the trigger and start layering in the best of the oil stocks today.

In the meantime we are now deploying in gold and silver stocks at what looks to be a major bottom. If you are a contrarian who understands the secular commodities bull and you want some of the best gold and silver stocks to own today, check out our new June Zeal Intelligence newsletter. Please subscribe today!

The bottom line is oil stocks do have a high correlation with the general stock markets in the recent years. This not only reduces their utility as risk-reducing portfolio diversifiers but it complicates the timing of uncovering major low points in oil stocks to launch high-probability-for-success long campaigns.

Nevertheless, with a powerful secular commodities bull now underway oil stocks are likely to be one of the best performing sectors in the coming decade. So the high XOI and SPX correlations shouldn’t scare anyone away, but they ought to encourage investors to be extra careful on buy-side timing decisions.

Adam Hamilton, CPA
June 10, 2005