The Future of Crude Oil Prices
The Smart Profits Report: Issue #329
Tuesday, July 11, 2006
The Future of Crude Oil Prices: How a New Saudi Development is Bearish for Oil Prices
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
On August 31, 2005, Hurricane Katrina had just devastated the U.S. Gulf Coast and dealt a serious blow to crude oil distribution and refining capacity. While the event was catastrophic, it was extremely bullish news for crude oil, and crude indeed hit an all-time high. I wrote on that day that due to a combination of sentiment and technical indicators, prices should head down. And head down they did, selling off 20% over the next three months.
Then, on May 3, 2006, I wrote about the confluence of technical indicators that signaled another intermediate top in oil. In addition, bullish news (nationalization of natural gas fields in Bolivia) failed to take prices higher. And oil dropped 8% off its highs in a matter of days.
And back in the Smart Profits Report Oil Forum on May 19 (see today’s Cribsheet below), I noted that after a major run, oil trading momentum was dropping and that prices were making a series of lower highs, down between $71 and $72 a barrel. This signaled that crude oil had hit a short-term top and that prices should head down from that point. True to form, that happened, as prices dipped below $69.
So why the review? Because history is repeating itself. Oil has again hit an intermediate top. Will oil go higher in the long-term? Yep. I’m a long-term oil bull. But are they done for now? Yep again. Technically, and from a sentiment perspective, the future of crude oil prices should once again take a breather. Here’s why…
The Case for an Intermediate Drop in Oil Prices
First, let’s look at the sentiment analysis. The simplest form of sentiment analysis (and one of the most effective) is news analysis. And we got a big story on Monday, with The Wall Street Journal running a front-page story about Saudi Arabian efforts to recover heavy crude oil.
Heavy crude is thicker and usually contains more impurities (sulfur and metals) than “light sweet” crude. In short, it’s harder (or nearly impossible) to pump and more costly to refine.
So why is this news? The Saudis have the world’s largest reserves of light sweet crude. So to show an interest in getting at their heavy crude is a bit of a policy change. And more importantly, the vast majority of their heavy crude is NOT included in their published figures for “known reserves.” So if they figure out a way to extract their heavy crude oil, that would increase the amount of oil the Saudis could sell. And that’s bearish for oil prices.
Most importantly from a sentiment perspective, crude prices reacted negatively to the news. And this came after an all-time high was made in crude prices. While price action that confirms news isn’t quite as powerful as a diverging reaction, it is still a very useful indicator.
And fortunately, we have some other tools in our analysis bag…
Technical Charts Show a Price-Momentum Mismatch
On the technical side, we have two interesting indications to look at. First, my favorite tool for gauging price tops (and bottoms): price-momentum divergence. Take a look…
This chart shows the test of the highs on Friday, July 7, 2006. But in true topping fashion, the price action rejected the new high and finished the day very weakly (a bar that is called a Key Reversal).
In addition, my favorite momentum indicator - the Moving Average Convergence-Divergence (MACD) - gives a clear indication. MACD is a tool used to show price momentum (or the rate of change of prices).
- When the MACD is moving up steeply, prices are accelerating quickly.
- When the MACD is moving down fast, prices are moving down at an accelerated pace.
So what this chart shows is price action that is mismatched with momentum. Prices are making nominal new highs, while momentum is divergent from the levels of the old highs. This is a bearish sign for prices.
What’s Next for Crude Prices?
While no analysis is foolproof, the intermediate-term case against higher crude is pretty strong. I expect to see lower prices.
The main risk factor in this analysis is an outside news event. This includes terrorist attacks, such as today’s seven train bombings in Mumbai, India’s financial capital, or other politically destabilizing news in oil producing regions. We’re also entering hurricane season, so be aware of the effect storms can have on oil prices.
Good Trading,
D.R. Barton
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Today’s Smart Profits Cribsheet
- Be sure to check out my analysis of oil prices in the Smart Profits Report Oil Forum from May 19. In it, I present the case for long-term bullishness, but a short-term drop - and why $68 is a key level. Visit it to read my take!
- Oil isn’t the only commodity we’re bullish on in the long-term here at Mt. Vernon Research. In fact, besides oil, the editors of our flagship newsletter, The Xcelerated Profits Report, are also bullish on three other commodity plays and recently gave readers specific investment recommendations on each. To find out how you can join them, please visit this link.
Related Articles:
- Profiting from Crude Oil: In the Age of “Perpetual Shock”
- Commodities: How to Create Your Own “Mini Hedge Fund”
- Event-Driven Markets: The ONE Case for Using Short-Term Options
The Chart of the Week
Today we’ll look at a crude oil chart one more time, for another significant piece of the technical analysis puzzle.
As you can see, the chart has a set of Bollinger Bands attached. A standard Bollinger Band is simply a price band with the upper and lower bands plotted two standard deviations above and below a simple moving average.
The amazing thing about the chart is that there was only two significant breaks of the upper band in the last year. Both led to big price drops. The third break of the upper band is from Thursday and Friday of last week, adding to our case for a downward price move.
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