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ENERGY: IS THE WALL OF WORRY CRUMBLING?

Over the last two years as the global economy recovered, commodity prices boomed in a bull market spearheaded by strong demand for Energy. Robust growth in China, historically low levels of inventories, and broad questions regarding OPEC’s ability to increase production and find spare capacity, were key issues fostering the wall of worry, which drove energy prices to multi-decade highs. Yet in recent weeks, as signs of a renewed slowdown in global growth have emerged, Energy markets and commodity markets in general have stumbled. During this period of time, the energy market has turned bearish from a technical point of view and now appears to be vulnerable to an even larger decline.

Starting with the big picture view, Crude Oil peaked an extended Third Wave advance in October of 2004. From that peak a sharp 25% decline unfolded between October and late December of 2004. This decline comprised Primary Wave 4 of the Bull Market in Oil. Under Elliott Wave Analysis, Bull Markets tend to move in 5 Wave advancing patterns, with Wave 5 in Crude Oil unfolding between late December 2004 and April 4^th, 2005. As would be expected, Wave 5 did advance to a new high for the Cycle with the early April peak in Oil moderately exceeding the former peak seen in October of 2004. At this point, a bear using just Elliott could strongly argue that the bull market top is in place for Crude Oil and that prices are now headed into a strong “third wave” decline, which could rapidly depress Oil prices toward $44 to $40 in coming weeks.

What makes the Bear Case for Oil more compelling in the near term, is the fact that over the last few weeks, a number of moving averages including the widely watched 50 day moving average have rolled over and are now in decline. Looking more closely at the daily chart for Oil, a potentially powerful double top formation was constructed with a peak on March 21^st at $59, and then a second peak at $59.55 on April 4^th. In addition, as prices broke down below the long standing rising trendline which connected a series of lows from December to February, the most recent rally attempt in Oil failed at the under-side of the formerly rising trendline. This is classic evidence of a developing trend reversal and adds credence to the bear case that Oil prices could tumble sharply in the days immediately ahead.

Obviously, a sharp decline in Oil would have widespread implications for a number of other markets not to mention the top performing Oil Stocks.

What would happen to Oil Stocks if Oil declined sharply from current levels ?

The answer to this question is that Oil Stocks are not that closely linked to the price of the underlying commodity, as would be the case for say, Gold and Gold Stocks, where the linkage is very strong. At present time, large cap Oil Stocks are reporting record earnings, boosting underlying dividends and buying back shares. What’s more, these same companies have not made the same mistakes they once did in previous cycles, wherein large increases in energy prices triggered large increases in CAPEX right at the top of the cycle. In these prior cycles, once CAPEX spending began based on the assumption of continued “high” Oil prices, oil prices inevitably tumbled leaving these companies stuck with commitments to long dated projects amid an environment of shrinking cash flow. That didn’t happen this time, as all of the leading majors have been very guarded and have barely increased exploration budgets this cycle. Finally, large cap Oil Stocks are currently not pricing in $50 Oil, or $45 Oil, or even $40 Oil. No. Instead these companies are still priced for $30 Oil and in many cases, have locked in through forward selling of production, some of the outstanding high prices for Oil and gasoline that have been seen in recent days. This means that future earnings will continue to remain robust within a stock market environment where solid earnings growth is becoming increasingly hard to find. By the way, the one area of Oil Stocks, which should be avoided are the Oil Service names, which currently sell at historically high P/E multiples and have seen very little benefit to their business, as a result of this bull cycle in energy.

Sticking with a view of major Energy shares, the widely watched Amex Oil Index is currently holding key support at its 50 day lower Bollinger Band which will come in at 807.30, give or take a few cents over the next few days. What’s more, this lower band is reinforced by a .382 Fibonacci retracement zone of the entire January 5^th to March 4^th Oil Stock rally which comes in broadly between 808 to 812. Just below the .382 Fibonacci support, the XOI has even more support at the 100 day moving average which continues to rise and closed Monday at a reading of 793.72, and that is now rising approximately .20 cents per day.

In addition to the support just below current levels for the XOI, it should be noted that Oil stocks are like, the market in general, quite substantially oversold. At present, both my Short and Medium Term Rydex Models for High Cap Energy are deeply oversold, with my Short-Term Model finishing Friday at +73.16, near the lowest levels seen since early January.

In addition to my Short Term Rydex Model, my longer dated Medium Term Rydex Model for High Cap Energy ended Friday at -79.09 and that is closing fast on the –100 oversold threshold.

Using this model, it is clear that downside action for high energy stocks should be getting limited, while not precluding a few more days of choppy behavior while Crude Oil remains under pressure. Using my Medium Term Model, the prior three medium term lows were fairly extreme at –175 on 1/13/2005, -162 on August 31^st 2004, and –207 on April 12,
 2004.

In addition to fairly oversold readings on the Rydex Models, my Dollar Weighted Put-Call Premium Ratio for large cap Oil Stocks ended Friday at .865, near the high end of its historical range which tells me there is still a great deal of fear present in the Oil stocks. This should mean that the XOI has a good chance to hold onto key support in the area of 795 to 807 no matter what the price of Oil does in the near term. Another aspect of declining Oil prices would be the bullish implications a decline in Oil would have for the overall U.S. Stock market. With the Federal Reserve hiking interest rates over the last few months, and growth showing signs of a sequential slowdown, many are concerned that high Oil prices have forced the Fed to maintain too tight a stance on rates and inflation for to long, a period of time. The concern is that by staying vigilant on inflation the Fed is fostering an atmosphere of tightening credit condition which is now hurting the U.S. and its highly levered “financialized” economy.

As a result, we have seen a fairly severe sell off impact the U.S. Stock market in recent weeks driving many of the leading averages to 5 to 7% deficits for 2005. Going forward, sharply lower Oil prices could be seen as relieving pressure on the inflation outlook and as result, could help the Fed feel more comfortable that it will continue to maintain price stability. Consequently, lower Oil prices could take pressure off the Federal Reserve to continue hiking rates, which would be a boon for the U.S. Stock Market. Add to this fact, the idea that the stock market is currently very oversold and the ingredients are in play for a sizeable market rally. Over the last few weeks, some very long term technical gauges like the McClellan Summation Index have declined to readings, which have immediately preceded major rallies in the U.S. market.

In addition, the psychological backdrop for the stock now reflects high levels of fear as a number of sentiment polls stand at the lowest levels seen in many years. Matching these readings of excess fear, is the Rydex Ratio, which I keep based on the movement of actual money ‘in and out’ of the bull and bear index funds at the Rydex Group. This ratio has been moving up aggressively over the last few weeks and is now near its 200 day upper band. In the past, whenever this gauge has moved up as rapidly as it has in recent weeks, the stock market has been close to an important trading bottom.

Finally, with regard to positioning capital in the equity market, at the present time, I believe that an overall rally in the S&P will help to boost prices for large cap Oil Stocks, which remain attractive and could also lead to a sharp rally in Financials, especially the major banks, and a rebound in cyclical names such as Defense, Basic Materials, and Transportation stocks, many of which are badly depressed at this time. On the aggressive side of the equation, probably no index would benefit more than the beleaguered Airlines stocks which are sporting a potential double bottom on the Amex Airline Index. If Oil prices are going to continue to decline, we should no fairly soon, as any move below $48.40 on Crude should be followed by sizeable downside acceleration toward the low $40’s. For the long suffering Airlines, this could be a welcome reprieve.

Frank Barbera

© 2005 Frank Barbera

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