Update: What to Look for When the Price of Oil Has Bottomed

Fri, Aug 14, 2015 - 8:38am

In February, we took a look at prior times over the past 30 years when the price of oil had fallen by more than half (here).

Our conclusion was that oil had probably not bottomed. In the event, oil formed a low a month later, in March, from which it rallied nearly 50%. It has since fallen all the way back to its prior lows.

So, what happens next? Right now, there is no clear indication that price has bottomed.

[Read: Don’t Expect an Oil Price Rebound This Side of 2017]

We previously drew several conclusions about what to look for at price bottom. The current price pattern is similar to two other instances. Let's review each one.

In 1986, the price of oil fell sharply and quickly, just like it has in the past year. The first rally failed near the 50-dma (blue line; arrow). Price retested the low the following month, then rallied into May before retesting the low again 4 months later in July (second circle).

In the chart above, note the positive divergence in MACD (lower panel) and that the 50-dma flattened out. Finally, note the "higher low" in price within the month of July (second circle).

The current fall in oil is similar: an initial low in February, a failed rally (arrow) and a low retest the following month. Price then rallied into June before falling back to the prior low now in August. The positive divergence in MACD (lower panel) is also similar.

In the chart above, what is missing is a "higher low" in August and for MACD to start moving higher. Those are things to watch for now.

1998-99 is also similar to today. This wasn't a sharp fall over a short time period like now and in 1986; this was a much more gradual fall over two years. Still, there are many similarities: a failed rally at the 50-dma (arrow); a retest of the low a month later, from which price rallied 30% (dashed circle). As in 1986 and now, a big rally failed and price was back at the prior lows 4 months later (solid circles).

In the chart above, note the "higher low" within the month of December before a one-month rally into January. In 1986, price then shot up higher; in 1999, there was one more failed rally at the 50-dma before price shot higher (second solid circle).

We are looking at a very small sample and even within this there are variations. But there are some useful learnings applicable to today.

Oil is not likely to "v-bottom": it will likely retest the low at least once. Look for a "higher low" to form. Right now, oil is still forging new lows.

[Read also: The Link Between Oil Reserves and Oil Prices]

The point of these failed rallies and bottom retests is to work off the downward momentum in price. That is why the slope of the 50-dma begins to flatten and the MACD shows a divergence near the low. Right now, the MACD is still declining.

The current price of oil is back at the lows from March. If this level holds, it could be like 1986: a quick low. If price falls below much further below , it's probably going to be a longer process, like 1999, with one more failed rally at the 50-dma. What happens over the next week is therefore important.

One final consideration is sentiment, which is now lower than at any time since 2000. In this time period, lows in sentiment have not always been near the lows in price; last autumn is one example. That was even more true in the 1990s. As we warned in February, energy experts have tried and failed to correctly predict the price of oil, which is driven as much by supply and demand as politics between the west, Saudi Arabia, Iran, Russia and others (data from Sentimentrader).

For what it is worth, "smart money" traders in the Canadian dollar and the Mexican Peso last week established record net long positions. These currencies are tied to the price of oil; in other words, these traders believe the price of oil is set to rise and raise the value of those currencies at the same time (data from Tom McClellan).

Bottomline: the price of oil has fallen 30% in a month and is still forging new lows. "Smart money" thinks the low is near, and "dumb money" sentiment is at a 15 year trough, so it possible a reversal could arrive soon. The best approach for investors is to first wait for a sign that big buyers are interested: look for a "higher low" in price and for the downward momentum to dissipate. Neither of these has happened yet. This was the pattern at other major lows in oil.

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