Trader’s Narrative

Crude oil is down more than 50% from its high of $147 a barrel. Where are the peak oil believers? the breathless analysts and cheerleaders of the commodity that warned of a Mad Max armageddon?

Physical peak oil, which I have no reason to accept as a valid statement either on theoretical, scientific or ideological grounds, would be insensitive to prices. …In fact the whole hypothesis of peak oil – which is that there is a certain amount of oil in the ground, consumed at a certain rate, and then it’s finished – does not react to anything…. (Climate change) is likely to be more of a natural limit than all these peak oil theories combined. … Peak oil has been predicted for 150 years. It has never happened, and it will stay this way.
Dr. Rühl, chief economist of BP

Last Friday, for the first time in two years, OPEC supposedly cut their production by 1.5 million barrels a day. I say supposedly because these agreements don’t mean much when the member countries are facing the same financial crisis. OPEC members are notorious for cheating on their quotes. So it is difficult to give them the benefit of the doubt today when they are in desperate need of cash from the only thing propping up their economy.

Here is an interesting chart showing the history of OPEC changes in supply. In recessions, when there is less demand for oil, price cuts or better put, announced price cuts, don’t have the same effect.

A walk down contrarian lane brings us to the The Economist cover from March 6, 1999 (see above). At the time oil was trading around $14 and thought by many to only be able to go lower. What we saw recently sentiment wise was the opposite of this where “peak oil” came to be bandied about incessantly in the media and taken as gospel to imply that oil could only go up.

Oily Bubble
Crude oil’s bubble like march higher was rationalized by two main proponents, Goldman Sach’s Arjun Murti and Mathew Simmons. Simmons argued for 150 year old peak oil rationale for a spike while Murti made headlines in May 2006 by predicting a “super spike” taking us to $200 a barrel oil.

Murti has since cut his targets repeatedly as oil has crashed through them. First $140, then $110, then $75 and most recently in a bold attempt to get ahead of the price, $50 a barrel.

Although Murti may not have intended his analysis to get so much publicity, it did and a lot of people came to believe that oil was somehow destined to continue higher. Thus proving once again that listening to “experts” can be dangerous to your financial health.

The charts however were telling another tale to anyone who cared to listen to their whisperings. Crude oil had all the characteristics of a bubble and it has imploded like one too. Looking a long term chart, you can see that it has easily sliced through long term up trend line.

If we are going to go through a deflationary period, then OPEC countries are in for a world of hurt because the demand curve has shifted. If they lower production, they hurt themselves, if they don’t and keep it steady or cheat by increasing it, they will flood the market with supply.

From a technical point of view, there is strong long term support for crude oil in the $40 area. I have no idea if we will indeed go that low. But if we do, I’d suspect oil to find strong footing in that area.

Here’s a historical chart showing the previous OPEC changes in production:

Source: Wall Street Journal

At the start of the summer, when oil was setting records and trading at ~$135/barrel I showed an interesting graph which showed the price of oil in gold.

I wanted to show that even priced in this currency - which many feel is superior to the beleaguered US dollar - crude oil was just too expensive and ready to come down to more realistic levels.

Since then the price of crude oil has fallen to ~$96 and many see it continuing the slide lower.

Elizabeth asked for a followup now that a few months have passed so here is a more recent chart:

Still Expensive?
To get an idea whether oil is still expensive, priced in gold, it depends how far you want to go back. If you look back just a few years, it has a bit more to fall. But if you go back to 1994 or 1999, then oil could potentially fall much, much more.

Consequences
While attempts at a new financial bailout is plodding through the halls in Washington, the consequence of any sort of bailout is that the price of oil will remain high. This article from Forbes explains why.

My personal conviction is that there should either be absolutely no bailout - allowing rotted financial institutions to declare bankruptcy. Or if the government gets involved, it should be state capitalism, not socialism. Which means that the US should follow the Swedish model and ask for equity. If they want to hammer out a deal quickly, they can use similar terms that Buffett got from Goldman Sachs (GS).

Time to ‘fess up. I’ve been horribly, horribly wrong on gold. So much so that now I’m afraid of being labeled a contrarian indicator!

So let’s see, in December I thought I saw a tentative double top in gold… which didn’t materialize. Instead, gold paused by trading sideways for a month and then continued blazing higher and higher:

To be fair, a double top formation is only triggered when the neckline (the dotted line on the graph above) is pierced. Since that didn’t happen, we didn’t officially have a double top, at least according to the widely accepted definition within technical analysis.

That doesn’t absolve me as I’ve been skeptical of a continuing gold bull market. And I’ve been wrong, wrong, wrong. Gold’s climb has been unrelenting. Just today it closed at $949.20 on the Merc, taking it within a nugget’s throw of $1000.

But while the price of the commodity is 12% above the swing high in November 2007, gold stocks - as measured by the Gold Bugs Index - are barely peeking above those levels. So if you’ve owned any gold equity, instead of the metal itself, you’ve lost out on a lot of money.

The k-Ratio
The discrepancy can be seen in the k-Ratio which shows a slightly downtrending chart (in the short term):

Since the k-ratio has entered a channel, the easiest strategy is to buy gold stocks only when it approaches the “floor” and to sell them when it hits the “ceiling”. I’m hesitant to venture into any trades with a longer time frame since I’ve been clearly off my game on this sector.

I think my mistake was that I used the k-ratio’s valuation message to mean that gold’s trend couldn’t continue. Boy have I been schooled. The valuation is still high - historically - but that doesn’t mean that a trend can’t continue. The k-ratio is an amazing tool but it is really useful in giving you the really big picture. For anything more granular it falls apart.

Seasonal Pattern
Surprisingly, the rise we’ve seen in the price of gold has been against the headwinds of seasonal patterns. Historically, the period of time from the end a year to the end of March of the next year has been a very bad time to be long gold. It is exceptions to such seasonality “rules” that remind you that the market doesn’t have to follow any dictates, no matter how well founded.

In case you’re wondering, the best time in the calendar to go long gold is at the end of August and into October. Traditionally, this short time frame has provided the biggest boost to the price of gold. But right now the summer is way too far away for me to use it to place any bets.

Sector Breadth
Finally, as an attempt to peer into the fog of future prices, lets do a quick review of the current breadth in the gold sector.

Almost 86% of the gold stocks that comprise the sector are trading above their 200 moving average. Since this is a strong bull market, the percent of stocks above their long term moving averages has been consistently high with only a few short blips lower.

In January it even reached the rare maximum: 100% - around the time that the Gold Bugs Index (HUI) topped out at ~480. This statistic tells me that if I want to go long gold stocks for an intermediate time frame trade, this isn’t it. Not even close.

Thanks to today’s strong close, 100% of the gold stocks in the sector are trading above their 10 day moving average. At the beginning of the month, that number was less than 10% - so again, this is not a good time to go long, even for a short swing trade.

The best combination of breadth is strong long term (200 day average) and weak short term (10 and 50 day moving average). A good example was in mid December 2007 when there were only 10% trading above their 50 day MA and 5% above their 10 day MA with a very high 60% above their 200 day MA.

I’m keeping a wary eye on this sector until it presents a similar setup and will post about it.