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Where is Crude Oil Going?

(March 27, 2011)

Dear Subscribers and Readers,

Let us now begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

In our January 9, 2011 commentary (“Our Dark Sides”), we argued that WTI crude oil prices could easily spike to $100 a barrel this year, given the reappearance of supply constraints, our outlook of a resurgent U.S. economy, and a benign slow-down of the Chinese economy.  Personally, I expected a rally in crude oil prices in the 2nd half of this year.  I did not (and neither did anyone else) foresee a civil war in Libya, Saudi Arabia sending troops into Bahrain, or the earthquake in northeastern Japan.  Interestingly—as shown in the following chart (courtesy of Goldman Sachs)—OECD total petroleum inventories (black line) are down significantly from last year's and are now at its five-year average level:

As we discussed in our January 9, 2011 commentary, the decline in crude inventories is an ongoing trend—this was first witnessed in the total elimination of the 90 million barrels or so in “floating inventory” (i.e. oil parked in tankers across the world).  The recent decline in the “official” OECD oil inventories to its five-year average is not a surprise given the ongoing recovery in the global economy.  Just as important, the fighting in Libya and the ongoing “simmering” in Middle Eastern geopolitics may result in supply disruptions in the future.  In fact, most of Libya's oil production (1.8 million barrels a day) is now shut in; to just 200,000 to 300,000 barrels a day.  Due to the ongoing unrest in Libya, EIA has revised its OPEC surplus capacity project down—from 4.4 million bbl/d in 2010; to 4.1 million bbl/d in 2011; and a further decline to only 3.1 million bbl/d in 2012:

In addition, consensus estimates suggest that Japan will need to import an extra 200,000 to 300,000 bbl/d in oil equivalents due to the shut-in of 25% their nuclear power capacity due to the recent earthquake.  While a de-escalation of the Middle Eastern conflicts will no doubt cause oil prices to decline in the short-run (Goldman estimates a $10 geopolitical premium given the record low speculative positions in the WTI contract), the structural bull market in oil remains intact.  This is not surprising at all given the resurgence in global economic growth, the continuation of the Fed's QE2 policy, and negative real interest rates around the world.  The structural bull market in oil will not end until either: 1) it collapses on itself (I don't see this unless until it reaches $160 a barrel or above); 2) cellulosic ethanol or 2nd-generation biofuels are commercialized—this will take at least a few more years.  

I now want to engage in a quick discussion on technicals.  As we've discussed over the last couple of months, our technical indicators on US and global equities have continued to deteriorate.  Specifically, while the NYSE Common Stock Only (CSO) A/D line has continued to make new highs, the NYSE CSO A/D Volume line has lagged tremendously.  That means while the number of issues rising vs. declining still look bullish, the “intensity” of the buying vs. selling has not been as impressive.  This is confirmed by the recent deterioration in Lowry's proprietary Buying Power vs. Selling Pressure indices.  In addition, the NYSE CSO Only McClellan Oscillator and Summation Index have also weakened considerably.  While this does not mean the Dow Industrials or the S&P 500 cannot make all-time highs, it does mean that the market is getting increasingly vulnerable to a deeper-than-expected correction.  We are going out on a limb here: Should the Dow Industrials and S&P 500 continue to rally this week on dismal upside breadth and/or volume, there's a good chance we will go short in our DJIA Timing System.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:

For the week ending March 25, 2011, the Dow Industrials rose a whopping 362.07 points, while the Dow Transports rose 151.62 points.  While both Dow indices experienced a very strong bounce last week, they are still below their mid-February highs.  More important, our technical indicators are still very weak, despite the substantial bounce in the major market indices.  While the cyclical bull market that began in March 2009 isn't over, there is also no evidence that the correction that began on February 18th is over—given weakening global liquidity conditions, geopolitical risks in the Middle East, and the lack of an oversold condition in all our sentiment indicators.  We thus expect the market correction to continue (our target range is 7% to 12% from its February 18th highs). We remain neutral in our DJIA Timing System, and may even shift to a 50% short position should the Dow Industrials rally further this week (on weak upside breadth/volume).

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators decreased from a reading of 17.5% to 16.1% for the week ending March 25, 2011.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1998 to the present:

After peaking at 30.8% (its highest reading since late February 2007) nine weeks ago, the four-week MA has plunged by 14.7% to 16.1% last week.  At the same time, the 10-week MA broke its 24-week uptrend that culminated in a four-year high just five weeks ago.  More important, this sentiment indicator remains overbought on both a four- and ten-week MA basis—and with the ten-week MA now in a downtrend (and combined with our bearish liquidity and technical indicators), I expect the market correction to continue.  We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position if the market rally further this week.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The 20 DMA rose slightly from 109.6 to 111.3 last week—but it has declined by a whopping 18.9 points since the end of February.  Meanwhile, the 50 DMA remains slightly overbought, despite a further decline from 122.6 to 120.5 last week.  With the 20 DMA below the 50 DMA, bullish sentiment (and the stock market) is thus biased to the downside (this downward bias is confirmed by our other sentiment indicators).  Combined with the overbought conditions in our other sentiment indicators, deteriorating technical indicators, the challenging global liquidity conditions, and ongoing geopolitical risks, we believe the market correction scenario remains in play.  Should the market rally further this week, we will likely go 50% short in our DJIA Timing System.

Conclusion: While the short-term outlook on the WTI crude oil prices remains uncertain (given its sensitivity to changing geopolitical conditions in the Middle East), there's no doubt that the structural bull market in crude oil prices remains intact, given ongoing supply constraints, rising costs of production, a resurgent global economy, and negative real interest rates around the world.  Barring any further surprises in the Middle East, I expect crude oil prices to settle in its current range for the next several months—and then slowly rally into the end of the year.  I would not be surprised if the WTI crude oil spot price touches $110 a barrel sometime in the second half of this year. In the meantime, US and global equities are getting increasingly vulnerable to a substantial correction.  Again, I expect the market to correct 7% to 12% from its February 18th highs.  We remain neutral in our DJIA Timing System and will even look to go 50% short if the market rally this week on weak upside breadth/volume.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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