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Hurricane Katrina made landfall in New Orleans at 5:45AM on Monday, August 29th. That day Crude Oil stood at $67.40, Unleaded Gasoline at $1.9650, Natural Gas at $11.26 and Heating Oil at 1.987. Since then, with the exception of Natural Gas (which has gained ground to $13.65), all three Oil related contracts have been weak with Crude Oil currently near $63.40, Gasoline near 1.7580 and Heating Oil about flat at 2.00. Despite massive follow on damage to the Gulf of Mexico infrastructure from Hurricane Rita and ongoing outages at U.S. Refineries, the bullish consensus has taken great solace in the idea that prices have yet to spike higher. The bullish mindset of the day with regard to Energy appears to run along the lines of, “Well, if prices haven’t gone up any further in the immediate aftermath of these two massive storms, chances are they have topped out and won’t move higher from here on.” While this mindset may yet turn out to be the case if the U.S. is lucky and has a mild winter, looking at the price action of the markets themselves suggests a very different potential outcome.
In the case of Crude Oil, which has spearheaded the now almost four year bull market in Energy, we see a long upsweeping parabolic curve. For commodity bull markets, the parabolic rise is the norm, where bull markets are concerned. In fact, years ago, technician Welles Wilder developed a technical gauge known as the Parabolic Stop And Reverse or SAR. A complex gauge, SAR uses an escalating tracking rate to cut down distances between entry and exit points, and becomes a kind of exponential moving average, increasing its tracking rate as a market more wildly in one consistent direction. Again, this phenomena of exponential advances is common in commodity markets. As can be seen in the chart above, where I use an optimized weekly SAR, the trend for Crude Oil remains very much to the upside with Crude residing well above its rising parabolic stop (the dotted lines). Until the weekly SAR is penetrated to the downside, technicians need to be very careful about calling a major top in Crude, as quite often Commodity bull markets will end with a bang and not with a whimper. In this vein, the “blow off” top is the most common phenomena crowning the peak of a long commodity bull. In the case of Oil, more technical evidence is present pointing to the idea that there could still be one more dramatic surge in Crude prior to the ultimate market high. Over the last few years, the Crude Oil bull market has traced out a very clean Elliott, five-wave bull market. Within this advance, Primary Wave 1 appears to have peaked in late September 2002 at nearly $31. This was followed by a long and complex A-B-C decline which bottomed at $26.50 in September 2003.
From that point forward, Crude began an elongated, or what is technically known as an “extended” third wave advance. Within this Extended Third Wave, prices subdivided into smaller sets of rising 5-wave movements. The peak of Primary Wave (3) was finally seen in October 2004 at $55 and was swiftly followed by a sharp 27% decline comprising Primary Wave (4), which bottomed in December 2004 near $40. Within Elliott’s work, “Third Waves” are always the strongest portion of an advance on a technical basis, and as such usually define the momentum peak of a bull market. This is clearly evident by an examination of Weekly MACD, which reached its highest value at Point A in late October 2004 as Primary Wave Three peaked. Since December 2004, Crude Oil has been rising within a five wave advancing pattern and has now completed what appears to be Waves 1 thru 4 of Primary Wave (5). The implication from the Elliott Pattern, is that Intermediate Wave 5 of Primary Wave (5) still lies in front of us, and where commodity market “bull markets” are concerned, this can often be THE most dramatic phase of the entire advance. The Gold Bull Market of the late 1970s peaked with an extended 5th wave, where in the span of just three weeks the gold price more than doubled, moving from $400 to $850. Supporting a strongly bullish stance on Crude Oil is the inescapable fact that over the last few months as Primary Wave (5) has been developing, momentum levels as measured by MACD have remained at very buoyant values. Note that at Points B and C on MACD (in the chart above), there was very little draw down on the gauge, with both of those peaks in close proximity to the momentum peak at Point A. Usually, by the time a final fifth wave advance is completing, momentum gauges are failing by a wider margin, even as prices move vertically in a blow off condition. With the MACD now quickly approaching the zero line, which could act as support, the odds are very high that within a few weeks, MACD will once again cross-over on the upside and with it, the final blow off to the upside in Crude will be underway in earnest. In order for Crude Oil to maintain the upside potential of a forthcoming 5th wave, it will be imperative for prices to hold above the April 4th high of $59.70 on the perpetual contract which on the nearby Nov. Crude contract comes in at about $61.40. A break below $61.40 on nearby Crude and especially below $59.00 (allowing for some slippage and a small margin of error) would imply that the peak in Crude Oil has already been seen. However, as long as Crude prices hold nearby support between $60.50 and $61.50 we must respect the upside potential which is still present in this market. Indeed, if Crude Oil were intent on moving substantially higher, the market should probably begin to rally in an aggressive fashion fairly soon, as the recent Intermediate Wave (4) decline which has unfolded post-Hurricane Katrina appears to have already run its course. From here, the first move should be back up toward the $66 to $68 zone over the next week to 10 days. If prices begin to once again trace out a building pattern of higher lows, then a full scale blow off could develop lifting Crude toward the upper end of its accelerated rising parallel channel. This would target prices as high $80 to $85 heading into the cold winter months of December and January.
Looking at some of the other Energy contracts, we see very strong, if not unprecedented levels of upside momentum present on the medium term charts. Like a ball being fired into the air, there is a point of maximum upside thrust which is never the peak height of the rising ball. Inexorably, the ball will continue to rise for a long period of time, but with less upside force behind it until all upside momentum is expended. Only then, will the ball roll over and begin falling back to earth. In calculus, the rate of change equation describes this behavior where the maximum rate of change is seen long before the final high. Put another way, where energy markets are concerned right now, just look at the MACD for Unleaded Gasoline or Heating Oil on the next two charts. MACD measures the upside thrust behind an advancing market and has continued making new highs in both of these distillate contracts over the last few weeks. The serious and almost irrefutable argument from these weekly charts is the conclusion that we are still facing much higher energy prices yet to come in winter, as the current levels of upside momentum on the weekly charts are virtually unprecedented.
In the case of Gasoline a very reasonable argument can be made for prices as high as $2.50 on the nearby contract while nearby Heating Oil, which is already in tight supply could spike closer to $3.00. The targets above would imply that gasoline at the pump could readily approach the $3.65 to $4.00 range this winter, and that assumes that there are no more hurricanes in the gulf where there is arguably another month or more left in hurricane season. Yet as bullish as the Oil related contracts appear, the super-bull chart within the Energy complex truly belongs to Natural Gas. Remember, that in the wake of Hurricanes Katrina and Rita, there is still a very large portion of U.S. production "shut in” and unable to produce new supplies of natural gas. Where home heating is concerned, natural gas is truly a major input as the majority of U.S. co-generation comes from gas fired plants. In the case of Natural Gas, one look at the weekly MACD essentially tells the entire story, --- it is off, literally exploding off the charts! Anyone wanna bet that this tidal wave surge in upside momentum doesn’t beget even higher highs? Odds are very long indeed that Natural Gas prices will come down in a material way anytime soon.
Instead, any kind of moderate to severe winter is likely to trigger an even larger spike in gas prices, which in my judgment could spike up toward the $20 level and stay between $15 and $24 for many months.
In the case of Energy Stocks, all of the above generally argues for Energy to remain a rather defensive, albeit periodically very volatile haven, relative to the broad stock market. At present, with the major market averages now firmly ensconced within a burgeoning medium term downtrend, energy has been victimized by “redemption selling.” Put another way, money managers who have big gains in Energy are selling energy stocks to offset building losses in other areas and sectors of the market. While the stock market is under pressure in coming weeks, energy stocks are likely to trend sideways in a large and wide swinging trading range. However, as the market approaches my medium term downside objectives near the 1065 to 1100 zone for the S&P 500, odds will be high that a market bottom will develop. Under that outcome, the Energy stocks would once again likely lead the market in performance heading into 2006 and could make substantially higher highs heading into the second quarter of next year. A quick look at the Amex Natural Gas Index reveals that going into the recent high, weekly momentum values were at extraordinary levels which are almost never associated with a final market peak. The result: Energy stocks could be range bound for awhile, but will likely continue to perform strongly well into 2006, meaning that ample opportunity remains for both traders and investors alike.
Frank Barbera
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