Is Oil About To Follow Gold Down? This Chart Says It Will.

by: Brent Hecht

Anybody who follows financial markets knows the direction of gold prices over the past year. This is not a secret. But what seems to be lost or hidden somewhere in the deep recesses of investors short memories is where EVERYONE "knew" that gold was going just one short year ago. Yes, most people have long forgotten their fail-safe plans to strike it big with their gold stocks and gold ETFs such as GLD. (If you got in at the right time, you DID make a killing on gold) And why shouldn't they, after all, the stock indices are reaching for all-time highs on a daily basis. Who needs gold when we have the stock market? It seems that CNBC has a different financial pundit on every hour that shouts from rooftop, "THIS IS NOT A BUBBLE." But I caution everyone, if we learn nothing from the past, then we deserve to lose. And just like with gold, most of us will, unless we heed the warning signs. Cyril Kornbluth may have been right, when he coined the phrase, "the only thing we learn from history is that we never learn anything from history."

Gold Prices from October 2007 to October 2013 - Weekly Chart

With that said, I want to turn our attention to the gold chart above spanning from October 2007 to October 2013. Notice the chart pattern formed here and highlighted by the red lines is a bullish pennant pattern. A bullish pennant pattern is a pattern that pauses to consolidate into a pennant shape and then continue higher. You can see from the chart, that there are 2 points labeled where the pennant tried to break above resistance and failed before completing the pennant pattern. Then it tried to break out a 3rd time only to fail once more. Please make a mental picture of this pattern.

Gold Prices from October 2007 to October 2013 - Weekly Chart

Taking a look at this chart, you can see that around the time QE3 was announced was when it made its 3rd and final attempt to break above resistance. EVERYONE was saying buy gold. Instead, gold did a nose-dive, and broke through several resistance levels to decline over 35% and will likely decline even further yet. And what are financial headlines saying about gold now?

Notice how the headlines say that gold is falling because of tapering fears, or a strong economy in general. And yet, gold prices are far lower than when QE3 even began. Don't listen to the headlines, they are only there to sell advertising. Its very simple why gold is going down. Gold reached a point where the buyers of gold were exhausted and there were fewer people left to purchase gold, versus sell gold. Why are buyers exhausted? For nearly a decade, people have been buying gold furiously due to expected inflation, record government debts, and a number of sovereigns buying large amounts of gold. As a side note, sovereigns are always reactionary, and will be the last one to the party, so if they are doing one thing, then it is wise to do the opposite. But back to the fact that sellers over powered the buyers. We can argue about the reasons behind this phenomenon for hours and still not fully understand it. But the real reason we are here, is because what happened to gold, is the same thing that is about to happen to crude oil.

Oil Prices from October 2004 to October 2013 - Weekly Chart

Look at the oil chart above during the same time period. The first thing one should notice is that the oil chart looks very similar to the gold chart. Second, it is a much more dramatic from the standpoint of time and price movement. The Oil chart ranges in price from $147 to $35 and everywhere in between. Just like gold, there are the first 2 points labeled where it tried to break out and failed. It then continued to form the pennant pattern before trying to break out a 3rd time on the news related to Syria this past summer. Only, just like gold, it has failed and is beginning its decline. How far will it decline? Who knows, but given the length and size of the pennant formation in this chart, it will probably move slower and possibly further on a percentage basis than gold.

What have the financial pundits been saying about oil? They are saying "buy" because the fed is trying to cause inflation, the Mideast is unstable, and sovereigns have record levels of debt. The scary thing is, they are saying buy oil for the same reasons they told everyone to buy gold. Just like gold, the financial pundits are about to be proven wrong again. Even with the Fed's best efforts to cause inflation, the October CPI just decreased by .1% and you can see from the CPI chart below that despite the Fed pumping $85 billion into the system each month, inflation is trending downwards.

Supply and demand is a much more reliable metric to tell us where oil prices might be going. Look at the oil chart below and see the US production. When you couple that with the weak demand caused by an over leveraged, troubled economy, the supply and demand picture for oil is weak. It would be wise to stay away from oil investments such as this oil ETF, USO.

Source: BLS

Source: EIA

So what does the oil market outlook tell us about the greater economy? Be careful to not listen to financial pundits when oil prices begin to plummet. What they will say is to "buy the stock market" because low oil prices are good for the overall economy. Common sense would tell anyone this is true and it doesn't take an MBA to figure this out, but lets try to think a little deeper than that before we believe the financial talking heads. We should look back over the past few years and see what was happening in the economy when oil plummeted from $147 to $35 in 2008, or when oil went from $115 to $75 in a couple months in 2011.

Second, lets ask ourselves why does the Fed need to target annual inflation rates of around 2 percent? Why don't they just try to keep inflation at 0? Put another way, why is a rising price environment so important to the Fed? Quite simply, the Fed's job is to make BAD DEBT TURN INTO GOOD DEBT. The economy that we now live in, is overleveraged with everything from credit card debt, to mortgage debt to, to student debt. (not to mention government debt) And if we were to fall into a deep deflationary cycle, it would spell disaster for our economy.


Look at the graphic above for the facts in 2013 related to consumer debt. When a society becomes so leveraged to the point US citizens are, there is less money to spend and when there is less money to spend, things begin to deflate. When things begin to deflate, "bad debt" becomes "worse debt" because things are worth less. So although lower oil prices are good for the economy, and ultimately you and I(the consumer), it is going to be a sign of the deflationary cycle that is already in motion. If that is coupled with a rising interest rate environment, you have the makings of a perfect storm. But interest rates are a conversation for another day.

Two previous articles that I wrote talked about going long on two of what I believed to be the best oil & gas companies in the stock market. Those being Magnum Hunter Resources (MHR) and EOG Resources (NYSE:EOG). These two stocks have treated investors well over the past 6 months, but with where I've just outlined prices going, these stocks should be avoided. I still love almost everything about these two oil companies. I just no longer like crude oil which is a large part of these company's portfolio.

Hopefully this was helpful to give you a different perspective on oil prices and the economy at large. The truth is in the charts and one cannot deny that despite the Fed's best efforts, we are entering a deflationary period. Remember, Soren Kierkegaard was right when he said, 'Life can only be understood backwards; but it must be lived forwards.'

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.