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Oil and XOI Corrections

Adam Hamilton, CPA
September 15th, 2006

So far in September, blood has been gushing in great torrents from many major commodities. As of this past Tuesday, gold had bled 6.0%, silver 14.1%, and crude oil 9.3% in just the first seven trading days in this month alone. Naturally with prices spiraling relentlessly lower, commodities sentiment fell off a cliff and cratered.

During my work days I always have CNBC on in my office, usually muted so I can concentrate on my research and writing. I do have closed captioning enabled though so text of what is spoken floats across the screen. If I happen to look up and a discussion on commodities is taking place, I usually unmute the TV to see what the analysts have to say. CNBC interviews considered in aggregate offer a good read on prevailing sentiment.

Some of the things I heard on CNBC this week were amazing, reflecting absolutely horrendous commodities sentiment. I lost count of the number of analysts who claimed that the “commodities bubble” is over and we are entering the bust phase. One gentleman who was interviewed compared the commodities stocks earlier this year to the NASDAQ mania in March 2000, implying commodities stocks are going to plunge.

A prominent CNBC host repeatedly made the assertion that this commodities bull was sparked by the September 11th terrorist attacks. Another fellow said that since the CRB Index broke its uptrend, the commodities bull has officially ended. These assertions are just plain silly, of course, but the mere fact they were airing en masse reflects just how damaged commodities sentiment has become due to the recent sharp corrections. They are easy to refute.

Bubbles and manias only happen when the general public becomes utterly captivated and sold over to a specific asset class so it is all they talk about and buy. There is no way this has happened in commodities yet. Until you can go to the grocery store and overhear random conversations about gold stocks while standing in line, until you can go to a cocktail party where the only thing everyone talks about is their junior mining stocks, there is no popular mania. And no popular mania means no bubble, period.

Commodities stocks today reflect the utter lack of a mania as well, highlighting the gross inanity of such a thesis. In June 2000, a few months after the NASDAQ top, the elite NASDAQ 100 stocks sported an average P/E ratio of 124.1x earnings! This week the XOI oil-stock index had an average P/E of merely 8.5x earnings. While 100x+ earnings is absolutely a mania, less than 10x is still a bear market. There has been no general commodities-stock mania, because with the exception of precious-metals stocks commodities-stock valuations have remained extremely depressed and undervalued for their entire bull.

And 9/11 sparking this commodities bull? Such an assertion is so ridiculously wrong it is laughable! In oil’s case, it bottomed in late 1998 years before 9/11. And if anything the economic disruptions caused by the government-induced hysteria and draconian air-travel restrictions post-9/11 hurt the oil market by reducing demand. Commodities are in secular bulls because their individual demand-growth profiles are outpacing their supply-growth profiles worldwide. 9/11 it totally irrelevant to this bull.

While these initial arguments I heard many times on CNBC this week are silly, the fact that the CRB has broken its uptrend is very true and worth considering. Since early 2002, the venerable CRB commodities index has never spent more than a few days at a time under its 200-day moving average or below support. But over the last couple weeks the intense selling pressure has driven it down deep under both its 200dma and support for the first time. This technical weakness is indeed unprecedented within this commodities bull.

While the CRB has no doubt broken down technically, I suspect most folks are forgetting that today’s CRB is not directly comparable to the CRB before July 2005. Last July the CRB was revised for the 10th time in its long and illustrious lifespan. Where oil comprised about 6% and energy less than 18% of the 9th CRB revision prior to last July, now oil and energy utterly dominate this index.

Over the last 14 months or so since this 10th revision, oil alone now accounts for 23% of the CRB index and energy in aggregate a whopping 39%! Today energy dominates the CRB. Not only does this render it not strictly comparable with its pre-July-2005 history, but it means that any sharp CRB moves are likely going to be sparked by underlying energy moves. As goes energy, so goes this latest energy-heavy CRB iteration.

Therefore if we can understand what is going on in energy, particularly oil which is weighted almost 4x heavier than any other CRB component, then we can better understand the CRB’s recent downside breakout. Due to this fact, as well as the open positions we have today in various energy stock and options trades, I am taking a look at the recent oil correction in this essay.

Oil is not only the key to the CRB, but since it is such a high-profile commodity it is the key to the entire commodities bull in the minds of many mainstream investors. If oil is really in trouble then the carnage in the CRB could just be starting, which could very well spawn more sympathetic selling in other commodities. But if oil looks fine technically, then all the gloom and doom choking the commodities markets today is just a temporary blip creating an awesome buying opportunity.

Whenever markets move fast and get scary, I find the best way to force myself to view them rationally is to look at their latest move in strategic context. While it certainly feels like the bottom has fallen out of oil in the last month or so, when this latest oil correction is viewed within the context of this oil bull to date it is neither the largest nor fastest. In fact, at least at this stage it is rather unremarkable in most aspects.

My first chart looks at major corrections in this oil bull back to 2004, a period of time which encompasses the lion’s share of the bull-to-date gains and volatility. Each major oil correction is numbered and labeled with the absolute correction decline, the number of trading days it took, and the average loss per day over the correction’s lifespan.

In order to define a major correction, I considered it any sharp slide in oil prices that happened right after a major upleg or rally that carried oil well above its 200-day moving average. In addition the subsequent slide had to drag oil back down near or below its 200dma to make major-correction status. Anything that fell short of this definition was just considered a pullback and is not analyzed, with the single exception of a recent mid-2006 minor oil pullback that is discussed later.

At several of its major interim highs, oil carved double tops in close proximity. In order to calculate these corrections, I always went off the second top of a double interim top even if it was slightly lower than the first top. This approach makes the correction metrics more comparable since it excludes the time between the double interim tops when oil was essentially just consolidating and not yet correcting.

In our latest major oil correction that feels so wickedly devastating in real time, the king of commodities has plunged 17.2% so far in just 25 trading days, or an average daily decline of 0.7% over this period of time. If your only source of oil insight was CNBC interviews, I am sure you would think that oil is heading to $40 and our bull is over. But somewhat amazingly given how horrible oil sentiment is today, this latest correction is merely average!

There were five major corrections before this one over the past several years, numbered 1 through 5 above. They averaged absolute declines of 18.5% over an average span of 33 trading days and yielded an average downslope of 0.64% per day. These average stats are very close to and actually slightly worse than our latest major correction of 17.2% over 25 trading days yielding a 0.69% per day downslope. Carefully consider this.

Sentiment in oil and oil stocks has been outrageously bad, I have never seen so much talk of the end of the oil bull as during this past week. Yet the major correction that spawned this terrible sentiment was merely average at best, really weaker than the average correction that preceded it in terms of absolute decline and duration! What feels excruciating in isolation often feels merely unpleasant when considered in context.

When you realize that there have already been corrections in this oil bull that were much deeper than our latest one, others that lasted longer, and others still with steeper downslopes, it is hard to get excited about the relatively mild oil slide since early August. In a pure technical sense relative to bull-to-date precedent, our latest correction was totally unremarkable and not extreme in any way.

If so, then why did this correction spawn so much negativity? I suspect a few factors have contributed to the perception that this correction is different in some way and hence more threatening.

First, most analysts are like most mainstream investors and they don’t consider recent developments within their bull-to-date context. Since we haven’t seen a sharp decline in the oil price since February, I suspect many analysts have conveniently forgotten just how volatile oil can be on the downside too. Without a knowledge of market history that is only attained by being a diligent student of the markets, it is easy to get swept up in current events.

Second, this latest oil decline flies in the face of oil seasonals, which are usually quite strong this time of year. A sharp oil decline in a month where it is statistically improbable is more likely to spawn fear than a sharp decline in a less favorable month. I suspect oil’s usual seasonal strength failed due to the lack of a catalyst. Without any geopolitical fires raging or any hurricanes swirling into the Gulf of Mexico, speculators had little proximate motivation to continue bidding up oil. In the absence of buying interest prices tend to fall.

But an interesting disconnect has emerged. Wall Street has been advancing the theory that there is a massive speculative premium in oil, that it is trading tens of dollars higher than it should be due to speculators gaming chaos in the Middle East. I don’t think this theory makes much sense though. The Middle East has been a cauldron of strife for centuries, wars are nothing new in this region. On top of this, oil has been advancing since 1998. Relative to the past 60 years of Middle East geopolitical turmoil, the last 8 during this oil bull have really been fairly calm.

Purely speculative markets tend to rocket parabolic, like the NASDAQ in 1999 and early 2000. But as the chart above clearly shows, this oil bull has been advancing slowly and conservatively, moving up at a moderate pace without any parabolic spikes. When a market rises moderately for years and years paralleling its 200dma, it is a sign of changing fundamentals, not speculative fervor.

This oil bull exists because world oil demand is growing faster than world oil supplies, and oil’s moderate and long-term secular uptrend reflects this. As Asia and the rest of the world aspire to Western standards of living, per-capita oil consumption is relentlessly rising worldwide. This is putting tremendous strain on existing oil capacity. Since it takes so long to find and produce oil, it will probably take another decade or more to rectify this core fundamental imbalance.

Fundamentals take years to change at best. It is inconceivable that the world oil market changed fundamentally since the latest 17% slump in oil started a little over a month ago. If fundamentals cannot change that fast then they still remain very bullish. So the recent correction based on speculators getting worried about a geopolitical/hurricane lull is a psychology-driven technical event. And such countertrend moves rarely last for long since sentiment changes so rapidly.

Oil has already experienced many sharp countertrend corrections as the chart above reveals. But none of these corrections altered the core bullish fundamentals underlying global supply and demand. Near interim tops traders get overly focused on the short term, they get scared, and they start selling. But a month or two later near the interim bottoms rationality returns and once again the spotlight shines its focus on the long-term fundamentals rather than short-term potentially bearish concerns.

If oil’s fundamentals haven’t changed during the latest sharp correction, then odds are today’s low prices will prove to be a great buying opportunity. Oil has been temporarily driven below both its support and crucial 200-day moving average. If you carefully examine the chart above, every other time this has happened in the last several years oil rallied sharply not long after. Such sentiment-driven technical breakdowns seldom last for long in fundamentally-driven secular bulls.

Per Relativity trading theory, the best time to add long positions within a secular bull is when a price temporarily retreats to or under its 200dma following a major correction. Interestingly fear in oil has been so rampant over the past week that it has driven crude to its lowest level relative to its 200dma in years. At its worst close this week, rOil managed to fall to 0.944x. Such dismal lows will probably prove to mark an exceptionally good bull-market buying opportunity.

With oil technicals considered within their bull-to-date context not all that bad, and oil’s latest sharp correction merely sentiment-driven and unlikely to last within a strong fundamental bull, today’s interim oil lows should have big implications for oil stocks. The vast majority of investors and speculators are not directly involved in the futures market so they get their oil exposure by proxy, via owning elite oil producers.

At Zeal we buy and recommend outstanding oil stocks and call options on oil stocks whenever oil gets this beaten down, and we did so again this week in Zeal Speculator. But we also had existing positions deployed from last summer the last time the XOI was very weak. Like everyone else long energy stocks, we have been hammered in the past couple weeks. With extensive energy stock exposure on the long side, I was curious to see how the XOI has reacted to oil’s major corrections. This next chart takes a look.

The exact major oil corrections rendered above are here superimposed on top of the flagship XOI oil-stock index. Sometimes, especially lately, the XOI corrects directly in sympathy with oil. Since the dates used to demarcate these corrections are oil’s and not the XOI’s, the percentage moves do not fully reflect actual XOI interim highs and lows. It is interesting though to see what the XOI has done while oil was correcting in recent years.

Between corrections 5 and 6 for oil, it had a modest pullback and consolidation last spring well above its 200dma that is apparent in the chart above. The reason I analyzed this particular oil pullback is because over this same period of time the XOI had a major correction that is evident below. This steep XOI correction in sympathy with this oil pullback bottomed this past June and drove the XOI to its lowest levels relative to its 200dma of this entire bull.

As more and more investors and speculators discover the vast potential in oil stocks, the XOI has become more responsive to oil prices in the last couple years. Back in 2004 during the first two major oil corrections, the XOI was more or less flat. It didn’t really start following oil lower until oil’s third major correction in 2005. This newfound affinity was to be short-lived though.

Late last August as hurricane Katrina finished plowing through the Gulf of Mexico and hit New Orleans, crude oil peaked just under $70 in a dazzling new bull-to-date high. But the day after Katrina made landfall oil crested and entered its fourth major correction. As you probably remember though, at the time there was not a lot known about how damaged oil infrastructure was out in the Gulf and along the coast. So oil stocks were immediately bid higher and rallied dramatically through the first half of oil’s fourth major correction.

While they eventually plunged and followed oil’s lead, the hurricane-driven XOI surge early on in oil’s fourth correction is probably just an anomaly. Since then, over the past year or so, the XOI has very much followed the fortunes of oil. Especially when oil is weak, the XOI really tends to fall in sympathy. This is readily apparent in the fifth and sixth major oil corrections above, as well as during the oil pullback between these two corrections.

Now for those of you long oil stocks and options like I am, it is encouraging to look at the past year’s major XOI interim lows relative to oil’s. Note that after oil hit its own major interim lows, marked by the blue arrowheads pointing up, the XOI started consolidating and rising immediately after. And within weeks of these oil lows, the XOI was rocketing skywards yet again. The XOI doesn’t tend to linger at lows once oil starts recovering.

If the XOI continues this behavior this time around, and oil is indeed near its latest major interim low today, then oil stocks ought to thrive in the coming months. Another spectacular rally such as the one we saw in late June is certainly possible. Like today, back then the XOI fell under its support and 200dma and worried a lot of people. But soon after this plunge, the XOI began to rally sharply in a magnificent winning streak. By late July, only about six weeks after its dismal oil-driven lows, the XOI had achieved awesome new bull-to-date highs.

Interestingly back at those mid-June lows the rXOI hit its lowest levels of this entire bull to date. But just this week fear in the oil-stock sector rose to such staggering levels on the oil weakness that the XOI almost fell as low relative to its 200dma again as it was back in June. Since the June reaction rally off such ridiculously oversold lows was explosive, we may have the potential to see another explosive XOI rally off of similarly oversold conditions very soon.

At Zeal we are always watching for hyper-oversold conditions where short-term fear temporarily overshadows long-term fundamentals. We then try to add long positions during these very times when most traders are scared, the best time to buy from a contrarian standpoint. This week we added new positions in Zeal Speculator since oil and the XOI looked too oversold to pass up. The time to buy is when most other folks are selling and everyone thinks going long is suicidal.

If you are interested in following our time-tested contrarian trading approach across major commodities sectors, you would like our acclaimed monthly Zeal Intelligence newsletter. In it we are constantly analyzing, relentlessly evaluating, and always looking for stellar trading opportunities in elite commodities stocks. When technical conditions look highly promising such as in oil and oil stocks today, we recommend new trades. Countless opportunities will arise as this commodities bull marches on, so please subscribe today so you don’t miss them.

The bottom line is nothing has changed fundamentally in the global oil markets in just a month. The sharp selloff in oil is merely a psychological response driven by fear-laden sentiment. Wall Street has convinced many speculators that oil fundamentals don’t matter and only crises drive oil. While not true, the lull in geopolitical and storm events in this past month has played into this prevailing mindset anyway and sparked selling.

Oil stocks have plunged in sympathy with oil, hammering those on the long side including us. Nevertheless, the technicals for both oil and the XOI considered in context show neither correction to be remarkable. They are both just average. And very soon after such corrections mature, oil and the XOI tend to start powering higher again in short order.

Adam Hamilton, CPA

September 15, 2006

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