Oil: The Beginning of a Long Term Downtrend?
Friday, August 1, 2008 | John M Is this Spam?We are continuously faced with expectations of $200 a barrel oil and gas prices hitting 6, 7, even 8 dollars a gallon by the end of the summer. Much of our lives are affected by the price of oil, making it easy for one to be “hysterical” about rising prices. Nevertheless, major oil industry analysts believe oil is significantly overvalued at a time when the media is losing all sense of ability to be objective while analyzing oil’s high valuations. Whom to believe?
Is last week's drop in oil prices a sign of things to come or just a correction before another run on its way to $200 a barrel? I personally believe that oil is beginning a new trend, and has created an opportunity to take bearish positions. (More on these later!)
About two months ago I began telling my parents, friends, and anyone who would listen, “not to worry, oil is extremely overvalued and, sooner rather than later, prices will begin to fall and continue downward for a long time to come.” My mother is really feeling the effects of high oil prices and wanted to believe me. She had a hard time believing I was right and that all the “smart people” on TV were wrong. Understandable. (We’ll deal with them in a minute.)
“Smart people” can tell you why unrealistic valuations are sustainable this time around. “Smart people” have the foresight to understand why the creation of the train, car, plane, Internet, and now dwindling oil supplies would mark a fundamental change in investment evaluations.
But then a funny thing happens: each of these life-changing events was followed by a bear market ... every time.
Let's take a quick look at how oil has been trading lately.
Notice the volume for the past two months. Down days are trading on increasingly heavy volume, especially last week. We may have a bounce here coinciding with oil’s next level of resistance made back in June. This bounce I believe will be followed by a downward trend through the support level toward $110 where the next level of support will be found.
Back In January I began to notice bearish signs. Specifically, MACD was displaying a negative divergence or “lower highs” when Oil was hitting “higher highs” as Chris Rowe demonstrates in The Trend Rider. You can see another one in the beginning of July. Oil is going up, up, up as momentum goes down, down, down. (Below)
Notice how MACD crossed the Moving Average, reversing into a bearish trend in early June followed by heavy upwards resistance. Oil continued up through June and Most of July. Finally, MACD and the Moving Average broke down as Oil lost $24 a barrel, pushing the Moving Average and MACD further and further apart (below).
Moving beyond technicals, oil barrels were down over 16% last week from $147 to $123. Outstanding oil futures contracts dropped to the lowest levels in 16 months, signaling that prices are too high for institutional futures traders.
There have been 13 consecutive weeks of falling demand in the U.S., leading oil imports to their lowest level since 2003. In the first 6 months of 2008, oil consumption is down 3.3% and major oil analysts are cutting their forecast for oil consumption in 2009.
Every time I turn on the TV, 90% of the commercials are about oil, energy independence, and the green movement. There are more commercials related to energy than there were brokerage commercials during the tech boom. Scary!
There is a global energy movement, and this movement is international as well as bipartisan. The number one villain of the energy movement: OIL. Make no mistake, the Western World is bent on limiting, if not eliminating the use of oil.
The left supports this on environmentalist grounds, the right supports it on domestic energy production, and both sides support freedom from foreign oil, especially moving trillions of dollars to the Middle East. Both parties are further being forced on board by the constant public outcry over rising gasoline prices.
Even oil companies are taking advantage of this historical opportunity to develop alternative sources of energy. This is unprecedented; oil companies have historically blocked alternative development for obvious reasons.
There will be increased domestic oil production, a wide nuclear power program, and breakthroughs in alternative energy products. And this is just for starters. How about cars that run on water for dessert? Think I am joking? Take a look!
Either way, oil is under attack, heavy attack.
What about the constant negativity surrounding oil prices from the media? This is powerful TV; nevertheless, Oil “hysteria” is not based on reality.
Let's deal with the media’s distortions right now!
1) "Demand for oil is up and is going to keep on rising as demand increases from developing nations, specifically, China and India.”
In actuality, demand is down globally over the past 6 months. The emerging world, including China, has slowed economically along with the West.
China’s Olympic push is creating unsustainable energy demands. Particularly, the demands resulting from Olympic based infrastructure projects. The Chinese have also decided to increase their Oil reserves by 50% in preparation for the games, making sure there are no energy related issues.
As the Olympics come to an end, the Chinese will then allow their oil reserves to dwindle back to pre-Olympic levels.
It is thus reasonable to infer that in 2009 oil demand will be significantly down globally.
2) "There is no such analysis as overvalued oil. Oil is a 'different' situation, the world lives on it, inventories are low, world supply is dwindling, and demand is growing.”
Hence, validated escalation of oil prices without respect for the actual evaluation of supply and demand.
This is absolutely false! Oil is like every other investment commodity or whatever else you want to call it. It will go through bull (expansion) markets, and Bear (contraction) markets based on high and low valuations, period. When the valuations become too high based on supply and demand, they will fall. “Hysterics” may drive the price up for awhile, but sooner or later institutions will no longer support this. The media cried the same story during the 70’s oil “crisis”.
3) "Speculators and oil companies are further driving the price of oil, unethically or even illegally, and there is no way to stop them without new laws.”
Well, I for one hear this as talking points for most politicians. But I have a question for our dear representatives!
If oil companies and speculators have the ability to raise gas prices artificially, why did they wait until now to do it? Meaning, for the last 30 years why was oil so cheap, and oil companies barely profitable?
The answer is simple: they simply don't have this ability. Speculators are riding the bull market just like every other trader would. The truth is, the government wants to put the focus on others.
Cheap gas coincided with a time when the environmentalist movement was picking up steam. Environmentally dangerous oil and nuclear power were the main targets. If we could clean up the country and import oil cheaply, who wouldn’t back this?
But as technology changed and oil was no longer dirty (Oil spills are almost obsolete), and nuclear energy became the cleanest, most efficient way to develop energy, we as a country did not change with the times. Here at home, there was just no reason to develop domestic energy.
Even as world demand increased, the U.S. kept its pro-environment, anti-domestic energy posture. Finally the “chickens came home to roost” and prices took off. Now they want to blame someone -- Oil companies, speculators, and OPEC. The Federal government alone makes 18 cents per gallon of gas sold at the pump -- more than the oil company itself. OPEC should pump more oil, yet we are unwilling to do the same?
With no relief from politicians, Americans have created the energy movement to fight high gas prices, a dirty environment, and gain freedom from foreign oil. The energy movement is here to stay, and oil has seen its heyday.
So if demand is declining, and oil was already way overvalued, why should the price continue to rise? What is going to happen when the western world decreases its use of oil by 10, 15, even 25%? Down, down, down to say the least.
The lesson learned here is similar to the lesson learned over and over again by investors: bulls come and go! Make your investment positions based on facts and informed outlooks. Do the research and form your own educated position.
"Smart people" may laugh at you, but you’ll be laughing all the way to the bank. I must say I am beginning to take the laughter as a compliment.
I will give you one absolute fact about investing that you can take to the bank with you:
“Eventually, what goes up must come down!”
I have positioned for a “contraction” stage in Oil by purchasing the Jan 130 put options (SYM: QSOMZ), on the United States Oil Fund (SYM: USO).
I have also moved on the Pro Shares Ultra Short Oil and Gas ETF (SYM: DUG). I believe we can ride oil down to at least $100 a barrel over the next 4-6 months. Below is a yearly chart of DUG.
(I understand the chart is a little hard to make out, sorry fro any inconvenience.) If you look closely towards the end of May, up days received a heavy increase in volume over down days. Institutional investors are starting to hedge against falling oil prices.
When it comes to oil, all true prices should be based on demand, inventories, and outlook on future demand. It doesn’t take a rocket scientist to understand that demand is heading down and will increasingly dwindle in the face of alternative energy sources. For me the writing is on the wall that it is time to become bearish on oil.
-- John Micheline
