Where Does Oil Go from Here?

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 |  Includes: OIL, USO
by: Cam Hui, CFA

As oil prices top $125 and take other energy prices higher, where do oil prices go from here? Crude oil appears to be overbought in the short term but sentiment doesn’t seem to be at a bullish extreme, indicating that there may be more upside in black gold. However, oil does seem to be extended relative to other commodities.

Fast money is in a natural gas crowded short
A look at the CFTC commitment of traders data shows two different faces of sentiment in the energy complex. While natural gas prices are nowhere near their all-time highs, large speculators (read: hedge funds) are showing record levels of skepticism in natural gas and they are net short the commodity. Readings are not only at a crowded short level but their bearish positions are off the charts.

Hedge funds long crude but not excessively bullish yet
By contrast, large speculators are net long crude oil but readings are not at an extreme level despite the record oil prices. This data from the CFTC, combined with public sentiment readings, suggests that in the absence of excessive bullishness in crude oil, the commodity does have room to move a bit higher given its positive price momentum.

Buying natural gas seems less risky than buying oil right now
The contrast in sentiment readings suggests that natural gas prices have more upside potential than oil prices and could hold up better should the energy complex correct. The chart below shows the price ratio of natural gas to crude oil, along with its long-term average and the one standard deviation bands around the average. I highlighted the price divergence between these two commodities in December and again in February. The natgas/oil ratio bottomed out in late December and has since turned up but likely has more to go.

A long natural gas/short crude oil position would have a potential upside of 15% today, based on the conservative target of reaching the lower one standard deviation band. If we assumed that the ratio moved up to its long term average, the position would have a profit potential of 50%.

Oil looks extended against gold too
Another way to look at oil is to look at its performance against gold. The chart below shows the price ratio of gold to oil since 2000. Gold prices topped out against oil prices in late December 2007 and the ratio reversed itself dramatically. Oil now appears quite extended relative to gold, as it does against natural gas.

The commitment of traders report on gold (not shown) shows that sentiment readings are relatively neutral. As a result, I would prefer a long natural gas/short oil trade rather than a long gold/short oil trade.