USO: Is a Probable Capitulation in the Works?

Friday's trading action in USO was just what the bulls were looking for, as USO exhibited characteristics of a typical capitulation, when its shares made a new all time low only to reverse their hemorrhaging, to produce a nice intraday reversal, closing in the black. The ETF made an impressive $1.34 swing on a 40% increase in average daily volume (especially noteworthy since so many traders were absent due to the holidays).

Dead cat bounce or trend change? The reversal was encouraging, but will it be temporary (bull trap) or did we actually experience a trend change? Are we still in store for lower lows and lower highs? A true capitulation occurs when all the weak hands finally can't take the carnage anymore and throw in the towel by selling to the smart money at important turning points. Could Friday's action be construed as a capitulation? Probably not, but it might just be a signal we are getting close.

Human nature is predictable: Most investors do just the opposite of what they should be doing, and typically follow the herd by buying late, and by getting greedy, trying to squeeze out every last dime as they search for an exit point near the elusive top. This type of approach often leads to total annihilation, as the holder ends up being part of the herd led to slaughter. Trying to buy at the bottom and sell at the top is simply gambling, and prudent investors should stay clear of this futile strategy as only the house comes out on top. Although Buffett's approach of being greedy when others are fearful and fearful when others are greedy is somewhat contradictory to this strategy, it is worth reiterating, as its approach stresses the significance of buying low and selling high.

Why most investors can't bear to sell: it's very easy to buy, but hard to sell. Most investors have no problem buying, but can't seem to ring the cash register to book their profits. They are afraid that if they sell, they will miss participating in further upward momentum, so they do nothing. On the other hand, when their investment goes into a dive mode, they tend to hold on to the bitter end, and when things look like they can't get any worse, they finally dump their shares.

This action further solidifies the premise that fear's impact on a trader's psyche has substantially more force than elation has. Investors end up doing the exact opposite of what they should be doing, as they end up buying high and selling low. Their mentality is, as long as they own the shares, they still have a chance for redemption. Once they sell, they are admitting defeat and cement the elimination of any chance of a comeback. It is ironic that most investors would rather hold their shares as they plummet to zero rather than sell them.They are simply too horrified of being subjected to the torture of observing their prior position, soar immediately after selling. Sound familiar?

Demand destruction is overblown: This relatively new term of "demand destruction" has become a recent trendy catchphrase of the copycat media. Soon they might be reporting about demand creation, because the average driver will be more prone to take that road trip he may have otherwise not taken due to dirt cheap gasoline. Supply destruction is on its way too, as OPEC cuts, drilling slowdowns and the perception of reduced oil output becomes sort of a self fulfilling prophecy. The down cycle could be on on its way out, as demand begins to chip away at supply. The North American drilling rig count has already started to soften, dropping 3.5% from 1781 units to 1721 units, and less drilling means less supply. The "drill baby, drill" mentality will quickly become a distant memory, as the fickle market has a tendency to routinely disregard the past. The combination of supply destruction and demand creation will eventually produce a substantial improvement in the price of crude.

Bottom Line: Don't try and catch a falling knife. Wait for the shares to commence a trend change and begin buying as USO starts to rally. Successful investors are basically effective merchandisers. They simply buy wholesale and sell retail. How else can you buy low unless the asset you are trying to buy is out of favor?

Begin accumulating near the $32 area, and start to average up as the shares rally. Make systematic purchases every $2.00 of incremental advances. Sure you are paying more, but you get what you pay for, and it is worth being on the same side as the trend. USO could easily rally to the $40 mark by the end of January, especially considering the bitter cold winter and escalating tensions between Israel and Hamas. If you happen to be long already, cost averaging down might not be a bad idea, assuming you are not too heavily margined. I usually shy away from this approach, that many profess is like throwing good money after bad money, but with bearish oil sentiment at record levels, it's hard to pass up.

Disclosure: Long USO.

Comments

[long_on_oil:]

I really like this guy. Fantastic article that hits most of US investors on the head. The human psyche is just as he said it is. I am going to bookmark this one and read it every time I am tempted to sell low...lol As my userid says I am long_on_oil so I have taken a beating during this downturn but I have sold nothing. I am stubborn as the Missouri Mule so I have been buying more BP and RIG...yeah call me nuts because I probably am...lol I have been thinking about buying some USO and now I know I will. Heck, I can't take what little I have left with me and the Wal Mart greeter job is looking better everyday.

2008 Dec 29 09:43 AM

[fireball:]

mark
thanx, very good article. very helpful on how to play this.
long on oil
thanx, lol.

2008 Dec 29 10:43 AM

[blu:]

I like this article as it points out a lot indirect influences that are in place.
His article on the 25th was good too.
Supply destruction is certainly our biggest worry now.
A list of all the mega-fields that are decreasing in production would make most peoples' jaw drop... But all the media talks about is "demand destruction".
The media rules our world these days... they wanted a Democrat, they wanted a recession, and now they want socialism. Woe is us.

2008 Dec 29 11:14 AM

[jjc7477:]

Ok Mark,

What gives? Here is your posting from the 25th article titled: "Buying USO is a no-brainer":

'Time to try and catch a falling knife: I usually don't recommend trying to pick a bottom, but with USO's extreme oversold condition, it is a definite buy at these give away levels. The shares have simply dropped too much in too short of a time representing a more than compelling opportunity. IF USO continues to fall, I would simply buy more to dollar cost average. The upside potential simply dwarfs the downside risk at this juncture. I suspect the downside potential is about $5, while the upside is more like $30.'

and now your posting from above:

'Don't try and catch a falling knife. Wait for the shares to commence a trend change and begin buying as USO starts to rally'.

If these two articles were more then four days apart there might at least be some reasoning to support the contrary positions, but now it just makes me question your credibility. Which way is it: buy now or wait until later???

2008 Dec 29 11:18 AM

[scotty1560:]

I like the article and USO (bought at $29-$37). Should be close enough to long term support for the "long term" buyer, only Mr Market knows the short term trading aspects.

Resigned to the fact that one might need to put this tracking stock away
for a few years, oil will come back, but when? For my taste if it hit $23-25,
I grab a little more, oil "should" have strong support in the $27-28 range.

I consider it more like owning real estate with a long time horizon built in
to have success. So tuck it away at these prices with a 3-5 year hold.
Everything works in cycles - read "Martin Armstrong's" - "It's Just Time"

2008 Dec 29 11:34 AM

[herbert hoover:]

"Friday's trading action in USO was just what the bulls were looking for.... The ETF made an impressive $1.34 swing on a 40% increase in average daily volume (especially noteworthy since so many traders were absent due to the holidays)."


Or perhaps word was out the the Israelis were about to attack Gaza? I believe that oil has only two directions for the next 6-9 months - down and sideways

2008 Dec 29 01:04 PM

[Ishortyou:]

Hm I wonder why people still bet on fossile fuel energy when new research and developement in other energy sources are coming out in the market.

2008 Dec 29 01:27 PM

[Mark Krieger:]

you have a point...the stories are a bit contradictory..I guess I changed my mind and USO is now sort of a dog with fleas until it crosses $32, then I would be a heavy duty buyer. I want to own this when it is going up, not when it is trading flat or down!


On Dec 29 11:18 AM jjc7477 wrote:

> Ok Mark,
>
> What gives? Here is your posting from the 25th article titled: "Buying
> USO is a no-brainer":
>
> 'Time to try and catch a falling knife: I usually don't recommend
> trying to pick a bottom, but with USO's extreme oversold condition,
> it is a definite buy at these give away levels. The shares have simply
> dropped too much in too short of a time representing a more than
> compelling opportunity. IF USO continues to fall, I would simply
> buy more to dollar cost average. The upside potential simply dwarfs
> the downside risk at this juncture. I suspect the downside potential
> is about $5, while the upside is more like $30.'
>
> and now your posting from above:
>
> 'Don't try and catch a falling knife. Wait for the shares to commence
> a trend change and begin buying as USO starts to rally'.
>
> If these two articles were more then four days apart there might
> at least be some reasoning to support the contrary positions, but
> now it just makes me question your credibility. Which way is it:
> buy now or wait until later???

2008 Dec 29 01:46 PM

[Ike:]

Look before you leap had an important comment on the Dec.25th article that is 100% pertinent here. I am interested in going long on oil but not so interested in USO now, see below


On Dec 26 02:17 AM lookbeforeUleap wrote:

> A simple warning for all who expect to make a killing going long
> on USO. I suggest you read the USO prospectus and familiarize yourselves
> with the methodology used by USO to make the Nymex contract investments,
> and the effects of contango. As the fund manager said, even if the
> price of the current month contract stabilizes at the price the previous
> month settled at, USO investors will lose 30% each month since the
> forward month contracts are all priced at over $40. The contango
> was more than $9 at the expiration of the January delivery contract
> on 12/19/08 - so if the February deliver contract simply maintains
> the $33 price that the January contract settled at, the purchaser
> of the February contract on 12/19/08 will have a loss of $9 even
> though the February delivery contract settled at the same price as
> the January delivery contract.
>
> USO sells the current month's contract and purchases the next month's
> contract 2 weeks prior to the expiration of the current month contract
> no matter what the price of the contracts, and as long as the future
> contracts are priced higher than the current month contract, that
> amount of price appreciation will never benefit the NAV of USO. Why
> do you think their are so many shorts on USO - only a fool would
> buy USO under the present conditions. Wait until the forward month
> contract prices come down, or the current month contract price stops
> dropping so precipitously, so that the contango decreases and when
> USO rolls out of the current month contract it can buy the next month's
> contract at relativley the same price or a much smaller premium.
> Until then, USO will not benefit in price appreciation and will even
> continue to lose NAV if the current month contract price simply stabilizes.

2008 Dec 29 02:06 PM

[scotty1560:]

ishortyou has a point but you don't switch energy solutions in a day or two
or a year or five years- expect 10+ years for technology to makes sense
in financial, functional, and practical terms.

Many Americans are addicts: addicted to sports, addicted to shopping, addicted to junk foods, addicted to television, addicted to medicines, addicted to oil, addicted to ipods, addicted to cell phones, addicted to celebrities, addicted to partisan politics, addicted to lawsuits, addicted to
gambling including stocks, addicted to power and money.
I'm no angel myself regarding "investing/gambling".

My bet stands: Americans are spoiled by "cheap" resources, so prices will rise until the pain hits the "junkies" hard enough. Just take a drive on an interstate highway and tell me how "responsible" the sheeple are. Driving 65 mph I typically rank in the 5% of slowest drivers. Sheeple race past me
to get to the light at an intersection.

Gas will rise again: Ballplayers and "stars" will make more money, casinos will keep growing, lawsuits and divorces will do fine, partisan politics and scams will continue in leadership positions, churches will encourage more babies,
militaries and related industries will beat the war drum.


So yea, thanks to the sheeple, my investments will do fine in a few years.
Natural resources are diminishing, and sheeple have no clue how to live
responsibly, politicians are "cheerleaders" for corporations. Stay tuned,
the "pain" is just beginning to be felt.

2008 Dec 29 02:38 PM

[kurt walter:]

USO is for trading. I wouldn't just buy and hold it till the sun burns out.

2008 Dec 30 01:45 AM

[Glen Bradford:]

Who knows man. I'm not going to be long USO when the turn happens, and I'm not going to get in early. Feel free to call capitulation points but you have to realize that the market is manic depressive. Especially when you have people who don't understand supply and demand or P/E ratios buying and selling stocks online.

You said it yourself: Don't try and catch a falling knife. Wait for the shares to commence a trend change and begin buying as USO starts to rally.

So, can we agree you bought in early, or can we agree to disagree?

I'm going to be long DXO when this shift happens.

2008 Dec 30 10:41 AM

[Mike_Templar:]

Driving 65 doesn't mean anything. My car (BMW 325i) gets better
mileage at 80mpg than it does at 55. It's all a matter of gearing.
Those drive slower mantras are from the days of 3 speed transmissions
and terrible engineering. Cars are now geared (especially German
ones) to run the highways.


On Dec 29 02:38 PM scotty1560 wrote:

> ishortyou has a point but you don't switch energy solutions in a
> day or two
> or a year or five years- expect 10+ years for technology to makes
> sense
> in financial, functional, and practical terms.
>
> Many Americans are addicts: addicted to sports, addicted to shopping,
> addicted to junk foods, addicted to television, addicted to medicines,
> addicted to oil, addicted to ipods, addicted to cell phones, addicted
> to celebrities, addicted to partisan politics, addicted to lawsuits,
> addicted to
> gambling including stocks, addicted to power and money.
> I'm no angel myself regarding "investing/gambli...
>
> My bet stands: Americans are spoiled by "cheap" resources, so prices
> will rise until the pain hits the "junkies" hard enough. Just take
> a drive on an interstate highway and tell me how "responsible"...
> the sheeple are. Driving 65 mph I typically rank in the 5% of slowest
> drivers. Sheeple race past me
> to get to the light at an intersection.
>
> Gas will rise again: Ballplayers and "stars" will make more money,
> casinos will keep growing, lawsuits and divorces will do fine, partisan
> politics and scams will continue in leadership positions, churches
> will encourage more babies,
> militaries and related industries will beat the war drum.
>
>
> So yea, thanks to the sheeple, my investments will do fine in a few
> years.
> Natural resources are diminishing, and sheeple have no clue how to
> live
> responsibly, politicians are "cheerleaders&... for corporations.
> Stay tuned,
> the "pain" is just beginning to be felt.
>
>
>

Jan 03 05:14 PM