Oil & Gas Cycles And Trends: A Complete Review

| About: The United (USO)

Summary

A detailed look at where oil and gas are in relation to the longer-term trend.

A guide for future price action and expectations.

Third article in the series providing a complete guide to trends in all asset classes.

Continuing the series looking at trends and cycles in various markets, this article focuses on two of the energy commodities, oil and gas.

The long-term cycles are very useful to set context, but they are not often at points where they can be traded. I will therefore look at some shorter-term cycles, and trade ideas, but with the disclaimer these can change.

I am using Elliot Wave and fractals to define trends, potential reversal points and future expectations. I also look at fundamentals, but usually focus only on what I think is driving the market. For example, I have a very basic view on oil; it has bottomed, but the initial recovery is being hampered by commercial hedgers scared by the Q1 crash and taking the chance to ensure survival. This simple context is reflected in the wave count.

Elliott Wave is quite simple to understand, but hard to master. I explained the basic concepts here, and there are many free resources on the web. It provides a framework to define stages of a trend and guide expectations. I don't know any other method that breaks down trend like Elliott Wave.

The Energy Commodities

In Q1 2016, oil and gas crashed to prices not seen in over a decade. The strong reversals since then suggest the lows are in and the cycles down have completed, but things are not as clear as they could be.

Firstly, oil and gas charts can get confused by the roll-over. There are ways to counter this, including continuous contract charts (where previous data is adjusted on roll-over), but I have found there is no perfect solution, and we must use whichever data suits the longer-term context.

Secondly, the cycles this year are not as distinct as we would hope for. The nature of the reversals and recoveries has been ambiguous and is safer to trade when there is shorter-term clarity. This will be explained in more detail below.

Although oil and gas appear to move in tandem, there are some key cyclical differences, both long term and short term. Gas has a cleaner and stronger recovery, and this could lead to higher probability trades.

Oil/The United States Oil ETF, LP (NYSEARCA:USO)

The February 11th low in oil came at a significant level, something I pointed out at the time:

Apologies for the little showboat, but I'm quite proud of that call, and it explains why the February low is important: wave "C" was the same size as wave "A".

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Additionally wave "C" was a well proportioned impulsive wave. It's not so clear in the above logarithmic chart (used to show the equality between wave "A" and "C"), but all the waves within wave "C" were related using linear measurements. As we would expect, wave 3 was clearly the strongest and longest, and measured just over 161.8* wave 1. Wave 5 and wave 1 were very nearly equal in size.

That said, the internal waves of the last decline in wave 5 (from the May highs) were not textbook, and actually look more like 3 waves. This has led many Elliotticans to say more declines are needed, but I think looking for perfect waves in every situation and time frame can lead to problems. Areas of long-term reversals are a battleground of longs vs. shorts, technicals vs. fundamentals, day-traders vs. investors, and so on. Expectation for perfect waves under these conditions is unrealistic. I think the count shown below is acceptable.

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This is a logarithmic view of the spot futures chart. Also, note the recovery is in 3 waves, ABC. This means the lows are not necessarily safe, and is another reason why some traders are bearish. If there was a 5 wave trend sequence, we could say the lows are safe, and we could be bullish for another wave up. That said, 3 waves can easily be followed by another 3 waves, and this is what I expect.

With so much inconclusive price action, we must look elsewhere for help. With oil, it is obvious where to look. Wave "A" ended a 77% decline, and so did wave "C". Are there any similarities to the reversal and price action following the decline?

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Тhere isn't very much data to compare so far, but there are parallels. Oil recovered 117% from February 12th 2011-June 2011. The 2016 reversal came just one day earlier, on February 11th, and again rallied (this time 100%) into a June top.

The current decline from the June top is deeper than the 2011 fractal, but remember it is only a guide. At times there can be an almost exact copy of past price action, and as amazing as this can be, it can also give us unrealistic expectations. We cannot expect a perfect replica every time. The tricky bit is knowing what sort of tolerance can be given to divergences. When is a fractal broken?

Until $35 is broken, I will give it the benefit of the doubt as there are other factors to consider. The S&P 500 and oil have an intermittent correlation; they both bottomed on February 11th and rallied together for much of H1. This is pretty much what happened in H1 2009 too, and you can see in the equity section below how S&P 500 price action has cyclical reasons to follow this period. If S&P 500 follows 2009, so could oil. This means we should expect a slow, steady recovery throughout 2017 into the mid-$60s.

We also have the comparison to 1990-1999 (note the chart below is about a month old, but this doesn't affect the idea). As well as the similarities in price structure and cycles, the markets in 1998-1999 had similar conditions. As oil's eight-year bear market slowly reversed, it was again accompanied by Saudi Arabia and OPEC in the headlines. Gold bottomed and spiked higher, Asia was in crisis, the S&P 500 had recovered from a 20% correction and was back at all-time highs. Interest rates may not have been as low as now, but the Fed did reverse a small cutting cycle with an initial hike.

The wave structure into the 1999 low was again ambiguous, but this didn't stop oil rallying strongly for the next two years. This recovery is stronger than that of 2009, but they both say the same thing; oil can be expected to rally throughout 2017.

At the moment, I am looking for longs, with expectation for a slow grind higher targeting the 2015 highs of $62.6.

Natural Gas/The United States Natural Gas ETF, LP (NYSEARCA:UNG)

As mentioned in the opening paragraphs, natural gas is cyclically different from oil, mainly because it topped in 2005 and has undergone three declines of over 70% compared to oil's two.

In terms of future expectations, this doesn't mean very much for the next decade or so. The three declines can be grouped together to make a wave "A", and the expectation is again for a long recovery in the form of a wave "B". In the very long term, it does hold significance as eventually there will be a wave "C" to a new low below $1.6.

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As with oil, we don't know exactly what shape or form the "B" wave recovery will take, but there is at least the potential for a much clearer cycle as long as gas gives us a 5 wave trend sequence up from the Q1 lows. More on this later.

Shorter time frames can gives us clues, as can comparisons with similar historical context and price action.

In this case, I have only one fractal that I am tracking, one I highlighted in my July article "Natural Gas Rally Hits A Major Inflection Point".

Rather than looking for a repetition (which would lead to new lows), I am looking for divergence from this bear market rally to signal the low is in.

As I wrote in July, a move to a new high beyond the $3 top would be significant as it would "complete a 5 wave trend sequence, break the channel, and break any similarity with past bear market rallies." All this would signal a change in trend and let us buy any retrace with confidence.

It looks like we may be about to get new highs, and the likely target is the usual wave equality where wave 5 equals wave 1. This would take price right onto the long-term trend line shown in the first chart at $3.23.

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It would be normal for an initial recovery to complete and reverse at the long-term trend line like this. Any subsequent retrace can be bought with the expectation of a break out on the next wave up. Therefore, there are potentially several nice medium-term trades setting up; short when the 5 wave cycle completes at $3.2, and reverse long for the next leg up if and when price retraces back into the mid-$2s.

Conclusions

Both oil and gas are recovering from multi-year bear markets. These "B" wave retraces will take many years and lead to much higher prices.

Oil's cycles are not very clear, but we can still look for longs into the $60s based on historical patterns and probabilities.

Gas will give us a clear 5 wave rally if it rallies above the recent high of $3. The rally will likely fade, but this sets up a high probability buy for a break higher.

This is the third in a series looking at cycles across the market. The first and second in the series are linked below. The fourth (and last) will look at bonds and currencies and attempt to reconcile the cycles. Not an easy job.

Article 1: Equities

Article 2: Precious metals

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in USO over 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.