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Crude Oil Bull Market Cycles Point to a Sharp Correction

Commodities / Crude Oil Oct 19, 2007 - 12:56 PM GMT

By: Zeal_LLC


Best Financial Markets Analysis ArticleAfter powering above $85 per barrel this week, crude oil is one of the hottest commodities around. Although this week's stellar prices haven't yet reached oil's all-time inflation-adjusted highs near $100 from way back in spring 1980, these new nominal record prices are really getting speculators' blood flowing.

Nearly everyone is bullish on oil, and for very good reason. Global demand, led by the rapidly-industrializing Asia , is growing relentlessly and will continue to do so for decades. Meanwhile existing oilfields are increasingly depleting, lowering production and raising costs. And despite vast sums of money poured into oil exploration globally, major new elephant finds have become exceedingly rare. And most of the world's known oil reserves sit in geopolitically-troubled regions, complicating recovery.

With worldwide demand heading inexorably higher, and worldwide supply getting pinched ever tighter, the only economic option for oil is a continuing secular bull market. Typically higher prices curtail demand, but this has definitely not been the case in oil so far. Since goods and people simply have to keep moving worldwide, the costs of transporting them are largely irrelevant.

Until oil prices get high enough and stay high enough for long enough for technological alternatives like synthetic fuels to really become commercially viable, global demand for crude oil will remain extraordinarily inelastic relative to its price. And since virtually all the oil pumped is burned for fuel soon after, there are insufficient above-ground global stockpiles to offset the shrinking gap between daily supply and demand.

For these reasons, oil really is the perfect bull market. I can't even imagine more bullish fundamentals persisting farther into the future than crude oil's today. And oil is the only secular bull market that I have trouble dreaming up end-of-bull scenarios for. Eventually years into the future, production of precious metals, base metals, and even uranium will catch up with and exceed demand ending their bulls. But oil is so hard to produce in the vast quantities our world needs that its bull run often seems quasi-perpetual.

But although this oil bull is exceptional fundamentally, it hasn't miraculously escaped the chaotic winds of sentiment. No bull, no matter how long it lasts nor how high it climbs, ever makes its journey in a nice straight line. Greed and fear constantly buffet its journey, rendering a sawtooth pattern on its chart. Bulls take two steps forward until greed peaks and then they retreat one step back until fear peaks. And then this cycle repeats ad infinitum as long as underlying fundamentals remain bullish. Oil is no exception.

If fundamentals lead a price to travel in a fairly straight line climbing to the right, ever-shifting sentiment pulls this line into a sine wave oscillating around its primary uptrend. While these bull cycles can be stressful for those not anticipating them, they offer great opportunities for prudent traders. Speculators and investors alike can buy low at the bottoms of these waves, getting the best prices in a bull. And speculators can sell high at the top and wait for the next bottom to buy again.

In light of today's incredible excitement surrounding oil, and extreme bullishness, we are probably near the top of one of these sentiment waves today. Greed is running rampant and most traders can't even imagine a sharp correction in oil given today's fundamental and geopolitical scene. Yet it is always just when traders least expect it that sentiment shifts for a season. And in oil, these shifts tend to be fast and unforgiving.

So anyone trading oil futures or the stocks of the companies that produce it needs to keep this oil bull's cycles in mind. Since I am both a long-term investor and short-term speculator in oil stocks, oil's near-term probabilities greatly interest me. Do the odds favor me adding long positions today in line with general bullishness or holding off on any new deployment until after a major correction?

In order to address this critical question, the sentiment-driven sine waves we have already witnessed in this oil bull to date must be studied. While the past never predicts the future precisely, it really does help define what is possible and likely . Since the emotions of greed and fear will always exist and vie for temporary dominance, the oil bull cycles show the general extent to which emotional extremes affect prices.

This first chart quantifies these cycles, illuminating the sawtooth pattern carved by greed-driven uplegs and fear-driven corrections. Although today's secular oil bull technically launched in late 1998 from just under $11 per barrel, between late 2000 and late 2001 a powerful cyclical bear interrupted this bull. It is from these 2001 interim lows of just over $17 that the current phase of our bull started. So there we begin this study of the oil bull cycles.

Each upleg and correction of this oil bull since 2001 is marked on this chart. For each major move, its absolute gain or loss as well as the number of months it took to run its course is noted. In order to define these major upleg-correction cycles, I generally considered uplegs to be runs exceeding 20% and corrections to be retreats exceeding 15%. This approach yields 9 major completed uplegs and corrections since late 2001, with oil's 10th major upleg now maturing.

One of the most entertaining aspects of this oil bull for me is watching traders and analysts talk about it on CNBC. Invariably whenever the oil price is forging new bull highs, they articulate ironclad bullet-proof cases about why oil can only go higher. Rather than looking at the hard evidence of history and being contrarian when greed waxes extreme, like weathervanes they simply reflect the general sentiment swirling around them.

But this fascinating oil chart does not have an emotional bias. It shows a very powerful secular bull, no doubt. But oil's rise has been as far from straight-line smooth as you can get. Yes, oil has advanced in very strong and profitable uplegs. But every one of these uplegs was followed by a hard and fast correction. Inevitably as any upleg matures, general greed and excitement grows too great. Once everyone interested in buying around that time has bought in, profit-taking selling overwhelms anemic buying and forces a sharp decline.

The 9 completed uplegs of this oil bull run have been incredible. They have ranged from quick and dirty 25%ish ones to monster runs approaching 70%. Overall, they have averaged 45% gains in just under 5 months each. These huge potential profits offered so often over the last six years show why traders are so enamored with this oil bull. Our current upleg, the 10th one, is not considered in these calculations. Until it has clearly topped in hindsight, its gains must be considered provisional for now.

But the yin to the uplegs' yang is the equally frequent corrections. They have ranged from fairly modest 15% declines to massive drops exceeding 30%. Now 15% to 30% may not seem too apocalyptic, but remember futures traders are highly leveraged with margin. These corrections, if not anticipated, are greatly amplified by this margin. Overall the average correction has lopped 22% off the oil price in just 2 months. If such a garden-variety correction happened today, oil would fall under $68 before Christmas.

So this bull-to-date precedent is crystal clear. Yes oil rallies mightily in its uplegs, but the cost of these gains is the inevitable subsequent corrections that bleed off the widespread greed these uplegs generate. You can't have an upleg without a correction any more than you can have a one-sided coin. This is just the nature of the financial markets since they are constantly tugged back and forth by greed and fear.

Enter our current enormous upleg. As of this week, oil has rallied a phenomenal 71% in just 9 months since January! Considering how gigantic the global oil market is, such rapid gains are truly extraordinary. After seeing such a monster run, today traders seem largely convinced oil is invincible. Due to oil's strong fundamentals and perpetual Middle East geopolitical concerns, they don't see any correction risk today.

Now before I did this research, I assumed that this latest 10th major upleg in oil was unprecedented within this bull. While technically correct, surprisingly this oil upleg isn't outside the bounds of precedent by all that much. Back off its dismal lows of late 2001, oil soared 68% in just under 6 months. Then over 13 months in 2003 and 2004, the King of Commodities rallied another 68%. So as far as big oil uplegs go, today's 71% run isn't too far outside the realm of precedent.

And interestingly, the corrections after these earlier big uplegs were on the small side . Upleg 1 saw an 18% correction in just under a month while upleg 4 dropped 16% in just under a month as well. Smaller but faster plunges lower can do as much to rebalance hyper-optimistic sentiment as larger but slower grinds lower. These corrections end once fear exceeds greed and most of the sellers have already sold. If oil corrected a similar amount today in its current big upleg, we'd see $72 before Thanksgiving.

The key point here though is not oil's specific downside target nor the duration of its decline, just that after major uplegs corrections are inevitable . Traders today not considering the growing risk of such a correction could find themselves in big trouble since oil's declines tend to be so sharp and unforgiving. The less such a sharp decline is expected, the more exciting oil looks over the near term, the higher the probability for a sudden correction becomes.

Oil's most recent major correction offers an excellent case-in-point here. In July 2006, oil soared to $77 on geopolitical concerns out of the Middle East as well as supply disruptions like the corrosion problems in the Prudhoe Bay pipelines. Many traders, including me unfortunately, were very bullish because oil tends to be strong seasonally in August and September during the late hurricane season. Oil looked ready to climb for another month or two before it corrected, but alas this was not to be.

Even though oil was not overbought technically in July 2006, even though that 9th upleg had only climbed 34% higher, general euphoria had ballooned too high so oil corrected anyway. And it was a particularly brutal correction, the worst seen in this bull so far. Oil plummeted nearly 35% in just over 6 months before finally managing to bounce at $50 in mid-January of this year. This not only hammered oil futures traders, but oil-stock traders as well. We had a bunch of oil-stock call options expire at losses.

This 9th oil correction was all the more remarkable because it easily pierced oil's support line, rendered above. Trading losses aside, this was actually a rather amusing episode academically. Since the newest CRB commodities index is utterly dominated by oil , commodities gloom-and-doomers came out of the woodwork to declare the ends of various commodities bulls in late 2006. Many of their bearish theories rested on the newly-revised CRB that was nothing like the historical CRB they so casually compared it to.

But a correction within a secular bull, no matter how sharp or how technically ominous, doesn't mean the bull is over. All it means is general fear rose to an unsustainable extreme driving unwarranted levels of selling. As long as the bull's underlying global supply-and-demand fundamentals remain intact, it doesn't matter how crazy any correction gets. The single biggest mistake traders make late in corrections is assuming fundamentals have gone sour rather than the far-more-likely scenario that the cause is simply fear-driven sentiment.

So since oil became so radically oversold in January, we shouldn't be too surprised by its enormous reaction rally to dig out of those lows. Most of this newest 10th upleg, as the chart above shows, occurred below oil's old uptrend channel. In fact, from just over $50 to just under $75 merely brought oil back up to its old lower support line. Its old resistance line, which has repelled the last 5 uplegs in a row like clockwork, is now in the low $90s. Obviously this isn't much higher from here.

But even if oil's awesome run higher this year is largely considered to be a reaction rally off of silly fear-driven lows in January, this doesn't negate the inexorable greed-fear waves oscillating through it. Regardless of whether this run was fully justified fundamentally or not, oil is up 71% in 9 months and traders are extremely euphoric today. When everyone gets greedy is when corrections suddenly spring forth and trap the unwary bulls with a vengeance.

Feeding into this thesis that oil ought to top soon and correct sharply, this commodity is now very overbought technically. One of my favorite technical tools is a simple concept called Relativity . In the greed-driven uplegs of bulls, prices pull far above their 200-day moving averages. And then in the following fear-driven corrections, prices retreat back down to their 200dmas. So the level of greed or fear in a bull at any time can be inferred based on where a price is trending relative to its 200dma.

This next chart looks at the oil bull compared to relative oil, or oil divided by its 200dma. This rOil value is rendered with the red line. After 9 major uplegs and corrections since late 2001, rOil has established a definite horizontal trading range. By examining how far oil has been able to pull away from its 200dma in these past uplegs before greed became too extreme, we can gain a better understanding of the probabilities for a sharp correction today.

Relative oil just expresses the oil price as a constant multiple of its 200dma. A value of 1.25x, for example, simply means that the oil price is trading at 1.25 times its 200dma. Curiously, over time the upleg tops within a given bull tend to cluster around a certain multiple of their 200dma. In the case of oil, this is 1.26x. While the 9 major uplegs prior to this one topped between 1.15x to 1.37x oil's 200dma, the average rOil top ran 1.261x.

All but the last two completed uplegs' tops happened at 1.24x or higher, so we have long been using 1.25x as the top of our rOil trading range at Zeal. Once oil pulls away from its 200dma by more than 1.25x, we go neutral on it and wait for a correction before adding new long positions. Sometimes rOil can head even higher than this, but oil still inevitably eventually corrects and contracts sharply back down towards its 200dma.

In this chart, oil's relative trading range is annotated with the same upleg and correction numbers used above in the bull cycles chart. Today our latest upleg 10 is trading at 1.288x over its 200dma. This is exceptionally overbought technically in the light of bull-to-date precedent. Only uplegs 3, 5, and 7 had rOil tops higher than what we are already seeing today. These were pretty sizeable uplegs too, running 50%, 55%, and 44% higher respectively.

And after stretching so far over their 200dmas technically, the corrections following uplegs 3, 5, and 7 were pretty ugly. They ran 33%, 26%, and 20% respectively for a 26% average. Often, but not always, the magnitude of a correction is directly proportional to the upleg that preceded it. Bigger uplegs generate a lot more greed at their tops so it tends to take deeper and/or longer corrections to dissipate this greed and return balance to sentiment.

Since our current oil upleg is not only the largest in this bull so far but also one of the most overbought technically, it would not surprise me at all to see a larger-than-normal correction. At 26% off of this week's highs, we'd be looking at $64 oil within a couple months or so. For traders prepared for such an eventuality, this would prove an awesome opportunity. But for traders trapped unaware in a sharp decline, they could really lose their shirts once leverage amplifies their losses.

And it is not just rOil that makes oil look extremely overbought today technically. I suspect that pretty much any technical tool you want to apply to oil would also show unsustainable greed evident in its price today. No bull ever marches higher in a straight line, and oil will also have to retreat one step back sooner or later to partially offset its huge two steps forward since January.

Personally, I will start looking to redeploy into oil stocks once oil retreats back down slightly under its 200dma again. This would correspond to a level around $65 relative to today's 200dma. We have long used an rOil level of less than 0.98x as our signal to start getting long again in oil-related trades. If you average all the rOil bottoms, they work out to 0.946x its 200dma. But this was skewed lower by the anomalous super-deep 9th correction of late 2006. Without that, the average rOil bottom is 0.969x.

Now as every upleg matures, strong arguments are advanced as to why that particular upleg must continue considerably higher. Today is no exception. Most of the short-term bullish arguments for oil today are geopolitical in nature. Analysts are acting as if current conflicts and escalations are new and exciting. But in geopolitics, just like in markets, there really is nothing new under the sun.

The Kurds have wanted their own nation since World War I hopelessly messed up the national boundaries in the Middle East . With Kurdistan straddling Turkey and Iraq it is no surprise that Turkey is worried that Kurds in northern Iraq will incite Kurds in southern Turkey to continue fighting for independence from Turkey . So Turkey threatening to send troops into northern Iraq is certainly nothing new.

And the Arabs wanting to destroy Israel is old news too. The Arabs invaded Israel in May 1948, massed on Israel 's border threatening invasion in June 1967, and invaded Israel again in October 1973. Realizing how much its neighbors hated it, Israel bombed the Osirak nuclear reactor in Iraq in June 1981 before Iraq could nuke Israel . Iraq rained missiles on unprotected Israeli cities during the 1991 Gulf War. Last month Israel bombed an alleged nuclear site in Syria . Interesting? Absolutely! New? Nope. This conflict has been grinding on for six decades since the Jews finally returned to their ancient homeland in 1948.

And despite these big geopolitical events and countless smaller ones over the years, oil still does not rise in a straight line. It flows and ebbs like all bulls. And it will continue to flow and ebb even if, God forbid, World War III erupts in the Middle East . A big conflict would certainly accelerate this oil bull, but oil would still need to correct periodically to bleed off excessive greed. Geopolitical flare-ups don't nullify this immutable financial-market trait.

So oil is growing increasingly overbought, and it will correct sooner or later. At Zeal, we'll certainly be ready for this buying opportunity. While we have been deploying capital to ride the red-hot gold upleg in recent months, oil and oil stocks are always on our minds. If you want to be ready for the next big buying opportunity in elite oil stocks that a major oil correction will bring, please subscribe today to our acclaimed monthly newsletter . It'll detail all our latest analysis in the months ahead and our actual oil-stock trades.

The bottom line is this oil bull, like every other bull market in history, powers higher in fits and starts. Yes oil's long-term fundamentals are breathtakingly bullish, and yes the Middle East is a mess geopolitically. But this has been the case for a long time now. Yet oil's general upward progress has still been periodically interrupted by sudden and sharp corrections to rebalance overly-greedy sentiment.

Today we have once again reached the point where hyper-bullishness in oil reigns. Few can even imagine it pulling back, let alone correcting hard. But it is when things look the most bullish, after the strongest runs higher, that corrections are the most likely to suddenly spring into existence. Oil and oil-stock traders would do well to remember this as oil euphoria grows extreme at this stage in the oil bull cycles.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at …

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit for more information.

Thoughts, comments, or flames? Fire away at . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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