Crude oil: Where to now?

June 30, 2006 04:54 AM

One of the most common errors made by traders is they adopt too many technical indicators and over optimize: paralysis by analysis.

For example, a client who had been day trading with modest success asked for trading advice, I saw a formation on a 5-minute bar chart that seemed to indicate a very strong close. The timing was impeccable; the trade was very successful and the client was amazed. He asked how I knew the market was going to make that move? It was simple: the chart indicators combined with movement in a related market confirmed the market was oversold. A rounding bottom formation also was present and when the related market began to move, the market in question began to rally as well!

The client was amazed. It was like he found the secret of life or the location of the Holy Grail. I explained that not only did he need to look at a five-minute chart but he could also add in other indicators: Bollinger bands, stochastics, the relative strength index (RSI), etc. and look to related markets as confirmation of market direction. And of course, there are the fundamentals of related markets and understand how they reveal useful information. When you get it right, the trade almost seems easy.

This was an eye-opening experience for him and convinced him that the secret to success was to find even more indicators to make his trading decisions. If that trade could be pulled out of a few simple indicators then the secret to beating the market was to follow every indicator he could find and locate related markets that would give him the true market direction.

He had a mission. He was going to program into his computer every indicator and algorithm he could find. He would incorporate every known market relationship and wasn’t going to trade until all the stars were in alignment. He was going to use his intelligence and computer savvy to beat the market at every turn. He would make no trade before its time and became a “technical obsessive.”

You can probably guess that his quest was not successful, the more indicators he tried to follow and the more market relationships he learned, the worse his trading became. With every new indicator he followed he was getting slower to the punch. By the time all of his indicators gave the signal to buy or sell the move was always long gone. He went from being a good trader with sharp instincts to a trader who had lost his way. He was trying to guarantee his success by waiting until every indicator confirmed his hypothesis. He went from a successful trading record to probably one of the longest losing streaks of his trading career.

There is a lesson in this story for all traders no matter how big or small. You cannot follow every indicator because by the time you think you have it right, the move is gone. There is no doubt regarding the value of many computer programs and market indicators; many people use them with great success but if you find that you are still struggling to make money despite having the best computer and all the latest gizmos, it may be time to turn off the computer, get out a pencil and paper and go back to basics. If your indicators are not working like they used to it might be time to break away. And by breaking away sometimes you can see the largest moves right under your nose!

One of the best bull markets in commodities has been the incredible bull run in the energy markets. One of my claims to fame as a market analyst has been my long-term consistent bullish outlook on energy. When oil prices were near $10 a barrel it seemed clear they could go to $40 and possibly higher. Even after oil made all-time highs, it was apparent it could go higher. Some people scoffed at this consistently long-term bullish outlook. The reason was that when people looked at the price of oil they had a preconceived notion of what was too high for oil and what was too low. When oil prices started to recover from their 1999 lows, what constituted “high prices” were distorted by the historical low levels and analysts were convinced prices could not go higher. When oil prices hit $25, they said that was the end, $30 a barrel was the level that was generally expected to kill economic growth and cause oil prices to fall; $40 per barrel was thought either to be unattainable or simply a short-term spike. Yet the truth is that if you understood the nature of how commodities work and had a basic understanding of technical formations, you could see the oil market was in the process of a major long-term bull market. The excitement had just begun.

At this point my client, nose deep in technical studies, may have determined that the RSI indicated overbought conditions and that it was time to get out, or God forbid, get short. Here is where paralysis by analysis can enter. The RSI, while a useful indicator, is best used to confirm an already solid signal or to help time an entry. Markets in full bull mode can chug merrily along in overbought territory.

Sometimes you need a map to get where you need to go. If you were to set off on a driving trip from New York to California, there are many roads and detours that you could take, but to get to your destination it might be nice to at least map out a general overview of which roads to take. The same is true to find out the long-term direction of the market and even logical spots for short-term peaks and corrections. The best way to chart a course may be to take a look at a monthly chart and have a sense of how commodity markets move (see “Just the beginning,” above).

Commodities are swingers. They swing from highs to lows and back to highs again. You can call it a cycle, or whatever you want, but the nature of markets is bull to bear and bear to bull. The oil market, perhaps more than most, has followed this boom and bust pattern. By recognizing that the drop near $10 was a bust, traders would have been able to anticipate the swing back to the highs. Even on a monthly continuation chart you could see the long-term possibility of this market. But to get a feeling of where this market could go you had to find out where the old high was.

Prior to the lows in 1999, the high in oil was set during the days leading up to the first Persian Gulf War. Oil at that time spiked above $40. Knowing that $10 oil was near a historical low, when the market bottomed, it was clear it would start on its long-term predictable path back to and beyond the all-time high. The monthly chart created a beautiful long-term head and shoulders formation that was obvious to even the most basic chart reader. And by knowing that oil swings like a pendulum between cycles of all-time highs and all-time lows, $40 was a logical place to take profits.

It’s almost funny to think back to 1999. Oil prices were falling. Then Energy Secretary Bill Richardson made a mercy buy of oil from the Russians for their strategic petroleum reserve to try to help them get some cash. It was almost hard to imagine a time when there would again be tight oil supplies. But cheap oil and a changing economy in China started to change the demand fundamentals. China became addicted to cheap oil and the market has not been the same since. The U.S. economy embarked on a huge expansion and the oil glut of 1999 turned into one of the greatest oil bull markets of our time.

But if markets always cycle between all-time highs back to all-time lows, why isn’t oil coming back to $10? Crude went into a super-spike mode. In other words, oil is now on a quest to extend its range to find a new high and possibly a higher low. This spike could take years or even decades to run its coarse but there is no doubt that once crude finds that level, we will again cycle back to the lows.

Despite near term weakness in the price of oil the monthly chart is still showing bullish characteristics. The key thing to look for to find that top is to follow the monthly continuation charts for a topping formation. For example: head and shoulders, rounding top and flags or pennants.

The way the monthly crude chart has corrected and held the lower trend line tells us the long term move is still pointing up. The 200-day moving average failed to keep the market down. That’s a strong bull sign.

On the fundamental side of this bull market the key to success was trying to get an accurate picture of demand. With the new dynamic of China in play all the reporting agencies had a hard time putting their finger on demand. As world supplies started to tighten alongside strong U.S. economic growth, demand for oil will increase. As for a slow down in the Chinese economy, as long as our economy is strong and we are importing goods from Asia, China will continue to grow. The Institute for Supply Management (ISM) Manufacturing Index is one of the best indicators of U.S. oil demand expectations. If the U.S. economy was able to grow despite all the challenges of higher energy prices, then most likely energy demand will as well. The ISM manufacturing Index posted the 23rd strait month of expansion, which is the longest string of expansion since the 1980’s. Of course the run on oil has also had an incredible 23-month push.

A long term chart is like a map of the market that often reveals a great deal more than a short-term chart. This is true even for day traders. A monthly continuation chart has more history and gives a sense of where this market has been and more important, where it is going. By having that long term sense of history, one can execute trend following trades and get a sense of where the markets are going to make major market turns. That way our friend can use all of his fancy technical knowledge to time his trades instead of paralyzing him from making a decision.

Phil Flynn is vice president and senior energy analyst at Alaron Trading.

About the Author

Phil Flynn is a senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. Phil is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets.