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Bullish Oil Play

|Includes:BP Prudhoe Bay Royalty Trust (BPT)
Bullish Oil Play

Courtesy of Rich Chappell (Springheel Jack)

From The latest Market Shadows newsletter: A Failure to Communicate: Numbers, Rates & Lies

I'm bullish for a number of reasons. The first reason is that the economic numbers are improving, so there is less likelihood of the US entering recession shortly. The second is that the top after the QE3 announcement looked very strange for a major top. I think a much better technical top could be formed by a higher high in the next three or four months to perhaps establish the sort of negative RSI divergence seen at the 2007 and 2011 tops. The third reason is seasonality. Generally, Decembers tend to be bullish, and the spring highs seen in 2006, 2007, 2008, 2010, 2011, and 2012 are arguing for a rise into another Spring high in 2013.

I have targets on short term patterns on SPX in the 1434 area, but SPX was failing to break over 1420 last week and closed at 1416. This is a significant area on the weekly chart as the weekly middle bollinger band (BB) closed the week at 1415. In the last seven years there have been fourteen moves from the weekly lower to middle BB, and three of those reversed at the middle BB to return to the lower BB. Eleven broke above. Of those, nine hit the weekly upper BB, which is now at 1456.5. The odds are good that we will see a break above. If we see a clear weekly close above the middle BB, the odds are good that we will see a test of the weekly upper BB, though that might be in the 1450 area when it is reached.

The fiscal cliff situation, and failure by US politicians to make an agreement, could certainly derail a bullish scenario for equities. If we are to see a more bearish scenario play out, then the likely failure area for SPX is at the highs last week.

Although leaning bullish, if the SPX breaks down through the 1400 support area, I will start considering the bear scenarios:

[click on charts to enlarge]

I posted the USO chart last week and looked at the bullish setup on oil, with a bullish falling wedge having broken up and a possible double-bottom forming. That gives a target at 34.7 on USO on any break up over 33. Here's that setup again on the daily USO chart:

The trade setup I'm looking at is on BPT, BP Prudhoe Bay Royalty Trust. This is a royalty trust currently yielding 12.6%. It has been beaten down over the last few months as oil prices have declined. From a technical standpoint, BPT has hit a strong support area between 69 and 72 from the 2008 highs that were broken and retested in 2010. BPT has bounced there so far on strongly positive daily RSI divergence and has broken the very steep declining resistance trendline from the last high. Bounces on this sort of positive RSI divergence delivered very strong bull moves in 2009 and 2011, and there is a possible double or W bottom setup on the chart that has a target in the 115 area on a break over 95.

The trade setup here is to take a full long position under 74, with a stop 10% below at 66.6. At 66.6, the strong support area for the current bounce would be broken. More conservative traders might put the stop at 69, and more aggressive traders might put the stop at 64. On a break below 64, I would expect more downside. If BPT runs higher, I would sell half at 90, and set the stop on the remaining position at 82.

If the W bottom broke up, I would sell the balance of the position at 114, slightly below both the W bottom target and near declining resistance from the 2012 high. Downside risk on this trade is 10% (setting a stop at around 66.6). If BPT makes it to 90 and reverses back through 82, then the overall gain would be over 15%. If BPT reaches 114 without reversing back through 82 from 90 then the overall gain would be slightly over 40%.

Downside risks: BPT might break down with oil, if oil breaks down. If there is any serious disruption in supply from BP's Prudhoe Field in Alaska, there might be a reduction of the dividend in response. Overall, however this is a steady earner in a market that looks likely to bounce over the next few months, the risk on this trade looks relatively low. Here's the setup on the BPT daily chart:

From The latest Market Shadows newsletter: A Failure to Communicate: Numbers, Rates & Lies

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Stocks: BPT