How to Use ETFs to Predict Price Moves in Oil

 |  Includes: USO, XOP
by: Oil and Gas Investments Bulletin

ETFs, or Exchange Traded Funds, not only track the price of oil, but they can actually provide clues as to where the oil price is going. I'll show you how to read their charts and show you the ETF that I think most accurately follows and even warns investors of oil price moves. (Hint – it's not who you think.)

Currently, light sweet crude futures remain in an uptrend, over the last month price has tumbled from former highs at $114.83 in May to $95.25 currently on the July contract. The two-year chart below, in 2-day increments, shows the course of oil prices with a continuous futures chart.

ETFs allow individual investors to partake in the price fluctuation of oil in a way very similar to simply purchasing a stock. (For further information on ETFs, see Keith Schaefer’s report: ETF Investing in the Oil & Gas Market).

The chart below shows the price of light sweet crude in yellow/red and two ETFs – USO, which is the United States Oil Fund (purple) and an ETF which gets far less attention – XOP (light blue). XOP is the symbol for the SPDR S&P Oil & Gas Exploration & Production ETF traded on the NYSEArca exchange – so it is an ETF that covers oil stocks/equities, whereas USO tries to track the commodity.

How to use ETFs to predict moves in the price of oil

Click to enlarge
(Click to enlarge)

General Chart Comments

From the chart above, much information can be extrapolated. Namely, we can see that at this time oil still remains in a primary uptrend, even though we have seen a sizable correction. There are two trendlines shown on the chart – the first one is red and indicates an aggressive upward trend.

At some point all aggressive moves slow down. The green trendline is also present which marks the more stable rise of oil prices over the last year.

If oil prices move below that red line, currently intersecting at $92 (this will change over time as the line is sloping), it indicates that oil is correcting to its primary uptrend level (green line).

The green line currently intersects at $80, but will rise over time as the line is sloping. An upward sloping trendline such as this helps a trader gauge when longer term trends are shifting. Markets move in waves - in an uptrend, markets have progressively higher low prices and progressively higher high prices.

If oil can hold above the $92 level it indicates strength, based on this simple method derived from former price action. On the other hand, if the commodity moves below that level we could see prices in the low$80s, where there is likely to be buying interest once again.

Using ETFs as a Form of Analysis

The ETFs shown in the chart are not only investment vehicles, but they are also analysis tools. USO (purple on chart) has already broken below its trendline (yellow line) indicating that lower prices are likely for that security. This provides some confirmation of the decline in oil, although XOP is a better gauge.

XOP provides valuable information. Not only has it been the far more profitable play from rising oil prices, but also generally leads oil prices – providing a bit of a snapshot into potential moves in crude.

This occurs because XOP is an ETF that doesn't track crude – it tracks oil exploration and production companies - which provide a large input the for the oil market as a whole and thus the price of oil. If investors are buying these securities, which are held by a sector ETF such as XOP, it indicates that the market is anticipating rising oil prices. The same situation applies if investors are selling these securities help by the XOP ETF in anticipation of falling oil prices.

Looking at the chart, XOP (light blue) has moved aggressively higher over the last year. Rarely did it pull back significantly, even when oil declined. I have highlighted a few sections of the chart for educational purposes. The first, light blue highlighted box on the left s (#1) hows XOP making a lower price high, while oil made a higher price high (all contained within the rectangle). This was a warning for oil prices and quickly oil prices corrected by about 15%. This is commonly called divergence.

The next box to the right (#2) shows oil correcting to the prior low yet XOP pulled back very little in comparison – oil quickly moves higher following XOP’s lead. The next highlighted blue box (#3) shows a similar situation to the last – XOP leading oil higher.

The final box is highlighted in white (#4) and is a potential warning signal similar to our first highlighted area. For the first time in over a year XOP made a lower high, while oil made a new high. This was a warning signal for the correction in oil and remains a warning signal. XOP has shown a strong tendency to lead oil prices and now it is retreating, leading oil lower.

You will notice at the far right of the chart, which shows June 15 price action, that while oil has paused near recent lows, XOP has retreated below its recent low. This makes further declines in oil likely, as long as XOP continues to decline or fails to rally on oil price rises.

Tying it together

Investors can use the XOP ETF to help them see the likely course the commodity will take. XOP has been a sound indicator for the strength of oil prices. It pointed to strong oil prices through the rise and even when crude corrected, it indicated a correction which has come and currently it is pointing to a further correction in oil.

In the beginning of this report the low $80’s was discussed as a potential target for the oil price.

If oil continues to drop below that level, we can look to the XOP indicator as a sign of a potential bottom. When oil makes new lows (compared to recent price action), but XOP fails to make new lows, oil prices have a high probability to begin moving higher as well.

While USO comes to mind when looking for a place to take advantage of a rise in oil prices, it has proven not to be the most efficient vehicle. XOP, when oil prices are rising, has proven to lead oil and also generally outperform.

Investors must remember XOP will also lead on the way down, retreating fast and more aggressively than oil; therefore, a prudent exit strategy is required. XOP also lacks the trading volume that USO has (still 2-10 million shares a day), yet it functions as an excellent analytical tool for oil prices.

- Provided & written by guest contributor Cory Mitchell, CMT

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.