Odds Favor Short-Term Slip in Crude Prices

Years ago when oil was $30 per barrel, we were laughed at when we suggested that it could trade over $100. Now it seems we were being a bit conservative.

That said, based on statistical tools we use to measure probabilities, we believe oil is currently overbought and due for a short-term correction of $20 to $35 before resuming a longer-term price climb that could well reach $200 per barrel.

The primary reason for the rising oil price is growing demand by China and India. Only a few decades ago, the planet’s two most populous countries were both extremely poor and inward-looking. Today they represent about 40 percent of the world’s population and their economies are growing at 10 percent a year. Both countries have embarked on long-term infrastructure spending and urbanization, and they are both of growing importance in the global economy.

This growth profile has led to a large increase in oil consumption. In the first quarter of 2008, China’s consumption of refined oil products rose 16.5 percent compared to a year earlier and crude oil imports were up 8 percent. And while India’s per-capita use remains very low, the sheer size of its population makes it one of the top five oil-consuming countries in the world and its imports are steadily increasing.

Let’s try to put oil’s risks and opportunities into context by using oscillators, which measure price volatility, to compare the patterns over long (20 years) and medium (five years) time periods. We use oscillators to track the movement of a stock or commodity through price and time to help identify overbought and oversold conditions based on the concept that prices move in waves. This allows us to use probabilities to manage risks and opportunities.

click to enlarge

The oscillator above measures the year-over-year percentage variations using a rolling 60-day rate of change over a 20-year period. The dashed lines represent one standard deviation above and below the 20-year mean ($30.14 per barrel, the light green line), and each solid line outside the dashed lines marks an additional standard deviation.

When oil price changes get up into the pink area, which is where we find ourselves now, the statistical signal is that it is overbought because such rapid price increases occur less than 5 percent of the time and the odds strongly favor a reversal. Following the same logic, when the trend line dips down into the blue zone, the statistics suggest that it is oversold and thus a buying opportunity.

The same trend signal emerges when looking at a shorter time period, as we see above in the five-year oscillator. Over that span, the average price (light green line) is $58.56 per barrel. The 60-day rate change currently shows oil to also be in the pink “overbought” zone that statistically favors a short-term price reversal.

Of course, the statistical trend can be trumped by unexpected or orchestrated events, as we’re now seeing in the Middle East. Hezbollah fighters have taken over parts of Beirut in what many Arabs in the region are calling a coup attempt against the pro-U.S. Lebanese government that’s being directed by the Shiite nations of Iran and Syria. The uncertainties created by this fighting have put upward pressure on oil prices – this benefits Iran, whose government appears intent on building a currency surplus to fund disruption in the Middle East. Any counteraction against Iran by the U.S. or Israeli military, while unlikely at this point, could trigger a straight-up move in oil prices.

It’s important to keep in mind that the oscillator is simply a statistical tool, and seldom would we sell 100 percent of any position based on what it tells us. However, when overlapped with fundamental analysis, the oscillator can help an active investor make better decisions on whether to be buyers or to take partial profits off the table at any particular point in time.

We are focused on the most undervalued energy plays based on cash-flow multiples, dividend yields and potential to substantially grow reserves per share in this environment. We note that the universe of stocks that fit this model has declined, so investors need to be very selective.

For more insights and perspectives from Frank Holmes, visit his investment blog “Frank Talk” at www.usfunds.com/franktalk.

Comments

[br1756]

Of all the statistical arguments about the price of oil, this one seems easier to swallow than the ones which compare the price of oil to the price of gold -- oil is consumed, while gold is recycled. As we approach permanent oil shortages I think it's very reasonable to consider ways to think about the oil price in terms of itself (or in terms of as-yet-nonexistent oil substitutes).

[eldon]

The price of oil will drop when the ETF, DCR Macroshares Down stops
trading. DCR is the reason the price of oil has gone up since February.
DCR was created for this specific time and place and purpose.

[AmesTiedeman]

Look at the spread today: 120 and change to 126 and change. This widening daily spread will be the climax to the break down next week..

[Kezorm]

Until a couple year ago, there was always more supply of light crude than there was demand. It was like a rope which always had slack. For a number of natural and artificial reasons, that has changed. Statistical arguments that do not recognize that fact are bogus. The more you pull on the rope now, the tighter it gets. Until someone begins to remove artificial inhibitions on potential oil supplies, or until high price destroys enough demand, the rope will tighten, price will climb and arguments based on the statistical behavior of prices during times of surplus supply... will fail.

[Aviv]

are those graphs take into consideration the inflation throught those years from my understanding some oil prices didnt even climb up in realistic figures??

[carloz678]

Aviv.

I agree with you. The huge head shown for Y2K does not seem correct. I was traveling in an RV that whole year and gas prices were extremely low and unchanging.