Investing in Oil

Investing in Oil

The Trader's U E-Letter: Issue # 150

Wednesday, August 31, 2005

Investing in Oil: Is Black Gold Finally Topping Out With Katrina's Help?

by D.R. Barton, Jr., Chairman, Trader's U

Oil prices may finally have a decent pullback.

Both technical analysis and market sentiment are showing some indications that the latest run by the crude oil bull may be ready for a temporary breather.

But let me be clear about investing in oil: I'm a long-term oil bull. And while I'm not smart enough to know where oil prices will finally find a trading range, it's sure hard to imagine prices settling below $40 a barrel in the long run, let alone below $30.

And much higher prices are the most likely scenario right now, based on the supply problems and demand pressures that are growing in the markets.

Or maybe not

Why Oil May Take A Break From Flirting With $70 Per Barrel

Let's take a closer look

Since there are plenty of good resources on the fundamentals of oil pricing, let's take a quick look at one technical perspective.

Unlike my long-term fundamental view, in the short term, I think the charts and sentiment seem to be pushing oil prices toward an overbought condition and a correction. Consider the chart below:

Investing in Oil: the Divergence Factor

While prices have continued to power up, notice the MACD (Moving Average Convergence/Divergence indicator - on the bottom half of the chart). MACD shows us how much thrust is behind a price movement. It takes the difference between the 26- and 12-day moving averages and plots it against a "signal line," or 0.18 on this chart. The signal line is the 9-day moving average. So if the difference in moving averages is above the signal line, there is increasing momentum.

In this case, momentum is slowing down as prices remain high. This technical divergence means that the higher price of oil is not well-supported by the direction of the moving averages. A chink in the armor of oil investing, perhaps?

To be fair, the same divergence could be seen at the temporary highs in late July and mid-August. While the market powered through those, we have some extra information this time around.

How Hurricane Katrina Can Top Out Oil Pricesand How It Relates to Investing

The massive hurricane that hit the Gulf coast could have caused a monster spike in oil prices. Instead, it may serve as the event that caused a quick top that leads to a short to intermediate-term correction. (Our thoughts are with all of those who are enduring hardships and loss in the aftermath of Katrina.)

When such a huge news event moves price only marginally, we need to see if the new higher prices can be sustained. So far (as of the close on Tuesday), the initial price spike has not been strongly supported, and further weakness here could signal the start of a sell off where investing is concerned.

An even bigger drop in oil prices could be looming, if we ever get the point where higher prices trigger a reduction in consumption. So far, such a reduction has been slow in coming. But the summer driving season is coming to a close. This seasonal phenomenon could combine with consumer fatigue (due to continuing higher prices) to start reducing consumption and slowing the demand on an over-taxed oil refining system.

Risk Factors in this Analysis

If the damage to Gulf oil rigs and, more importantly, refining capacity is more serious than presently presumed, such news could send prices higher. And in this current volatile environment, new supply disruptions anywhere else in the world would most likely be magnified and have a larger upward effect on price than usual.

But without significant new outside influences, there is a good chance that the relatively mild price reaction to the terrible news from the hurricane will signal a near-term top for crude prices.

Picking tops is a dangerous game in investing, but pullbacks can be played prudently, given proper use of stop loss levels and position sizing.

The Chart of the Week

Chart of the Week: AMZN breakup or bounce back?

Amazon has spent a week testing the support level established by its gap-up in late July. A breakdown here should send the stock back to test the $38 level.

Great trading,

D.R.

D. R. Barton, Jr., editor and founder of Trader's U. Barton is chief operating officer and risk manager for the Directional Research and Trading hedge fund group. He is also one of the top-rated national speakers, lecturing on stock and futures trading, along with other key strategies for investors.

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