You may recall that we went long oil and some oil ETFs towards the end of September, when it looked like a bull Pennant had completed. Everything went to plan for a few days with oil looking like it was breaking out upside – it did make new highs, whereupon we raised our stops, but the breakout aborted and it slumped back into what became a tedious trading range. After we got stopped out at about our entry point we largely ignored it as there was no clear pattern and thus not much reason for us to risk getting involved with it.
Now there are signs that this is changing fast – at the time of writing oil is breaking down from this trading range and looks set to back hard.
Going on price alone you may be tempted to think that oil is a buy here, after dropping for 6 days in a row, as we can see on the 6-month chart for Light Crude shown below. However, the volume pattern looks bearish. The drop so far this month has been on heavier than normal volume which has had the effect of driving volume indicators to new lows – way below where they were at the August trough. This persistent heavy downside volume implies that oil is on the verge of crashing this support and dropping much more steeply, and at the time of writing it appears to be, with the broad market dropping hard too.
The 2-year chart for Light Crude is potentially horrendously bearish, because if the giant sideways pattern from the start of the year is not a base, but a continuation pattern, then clearly another massive drop could ensue soon, and with the price and its moving averages now quite tightly bunched together and the latter in bearish alignment there is plenty of room technically for another devastating decline to occur.
Let’s take a moment to consider why oil might drop hard soon. The reason is simple – global recession / depression, which is exacerbating a massive glut in oil that could force the price a lot lower still. This supply and demand situation completely overwhelms bullish factors associated with what is going on in the Mid-East, barring a full-on World War 3 scenario centered on the region. Politicians and the media are rigging various data, like employment statistics, to fool the unthinking masses into believing that an economic recovery is around the corner, but the chart below for the Baltic Dry Index tells a very different story of collapsed demand for shipping and extremely weak world trade, even taking into account the greater number of ships available. Economic recessions and especially depressions are known to reduce the demand for oil.
Thus, the outlook for oil is grim indeed. How far might it drop? The mid-$20’s would seem to be a reasonable objective, given that global stockmarkets look set to rollover and drop before much longer. On the 10-year chart for Light Crude shown below we can see that a drop of similar magnitude to the one preceding the large holding pattern that has formed since the start of the year would result in a calamitous decline to about the low $20’s. This might be the point at which the Saudi oil sheiks are forced to auction off their Bentleys and Lamborghinis and at which the local population might get decidedly restive. If you want some fundamental reasons why oil should continue to drop have a read of this or this.
What will happen to oil stocks if oil drops hard like this? This is easy to deduce - they will drop hard to new lows, with any such decline being exacerbated if the stockmarket generally is weak too.
On the 6-month chart for the XOI oil stocks index, we can see that it has had a good time riding on the coat tails of the broad market since late September, but the party appears to be over and it looks like an intermediate top is now forming beneath its falling 200-day moving average. It looks like it is getting ready to drop and it fell quite hard today.
The 2-year chart for the XOI index exposes the recent rally as a common or garden bearmarket rally that has peaked right where you would expect it to – at the top of its downtrend channel, at a zone of resistance and beneath its falling 200-day moving average. It should now drop away and make new lows.
The 10-year chart for the XOI oil stock index makes clear that oil stocks are still quite pricey, especially considering how low the price of oil is now compared to where it was about 18 months ago. This charts reveals big downside potential - the XOI could easily drop to its 2008 lows or even lower.
There is a final point worth making here, which is that while a continued drop in the oil price might be viewed as just a part of a general drop in commodity prices due to global recession / depression in the face of a crushing debt burden, there is no comparison between the supply and demand situation in oil with, say, gold. Oil is being pressured lower by a massive glut. There is no such glut in gold – on the contrary, if Central Banks resort to emergency money creation, threatening a hyperinflationary depression, investors could very quickly discover that behind the façade of naked shorting, there is very little physical gold to be had. This means that gold could soar even while oil prices are collapsing. End of update.
Posted at 10.15 am EST on 12th November 15.