Oil Charts Bringing Clarity

In a recent issue of Bourbon and Bayonets, I discussed the potential for a massive correction followed by a period of consolidation in the commodities markets.  It turns out there was more than potential, and none of the commodities were saved.   If you were long the commodities during the month of July, whether it was stocks and ETFs or futures and options, you took it on the chin.

In fact, in the month of July the Reuters/Jeffries CRB Commodity Index had its worst month in 28 years.  The index declined by a 10% margin.  The first few days of August haven’t been any better either.  While I’m writing, the CRB is currently closing out trading on its largest single day decline since March.  Like I said, if you were naked long ANYTHING in the commodities sector, you got burned.

Now, as readers of Bourbon and Bayonet, we were able to look at a conservative trade in the commodities sector and not expose ourselves to violent price moves.  By considering going long gold and short oil, we were able to give our portfolio necessary exposure to commodities markets, and still avoid the market whipsaws.  And just if your keeping track, the trade is up approximately 10% since I wrote about it just a few short weeks ago.

Although I still think that spread has a long way to run, that’s not what I wanted to write about today.  In today’s article, I will discuss one side of that trade.  By using just a little bit of basic technical analysis, I can try and figure out just how far I think the oil correction will run.

Oil Crystal Ball
We are going to focus on charts involving two markets: The U.S. dollar index and light sweet crude oil.  Obviously these are markets are correlated and actually have near perfect inverse relationship.  As a precious metals guy, I’ve read many charts involving the PMs, oil, and the USD, and have much experience in doing so.  Below are the 3 month daily charts of the U.S. dollar (USD) index and light sweet crude (WTIC).

I would like to focus on the recent correction that really got going the second week of July.  As you can see, the dollar rallied 2.5% while oil dropped 17%.  A little back of the envelope math gives us a 6.8% move in oil for every 1% move in the dollar.  The natural thing to do now, in order to try and figure out the bottom for oil, would be to figure out how much higher can the dollar rally.

For that, I am just going to blow up the 3 month chart of the USD index into a 7 month chart.

There is something that really jumps out to me in this chart.  Notice, that since the lows of 71, the index has a near term high of 74.  When the index finally got its legs back under it at 71, 74 would have been a good guess for an interim high of a bear market rally.  The reason is that 74 marks a nearly perfect fifty percent retracement line in a bear market correction.  So we will already have strong resistance their.

The other part of this chart that concerns me is that 74 also lies immediately below the 200 day MA marking another form of strong resistance.  Given the large amount of resistance, although there’s no sure thing in financial markets, it will be extremely difficult for the dollar to break the 74 level.  I fully expect the index to form a bearish double top formation at 74.

That means that the dollar will probably move another 1% to the upside before turning south again.  That correlates to another 6.8% decline.  Using today’s close of approximately $120, we would be looking at another $8 of correction, or $112 oil.

Oil Technicals Are Right On
As you can see, we’re piecing together a technical puzzle with the goal of knowing ahead of time what the markets will do.  So I’ve computed some numbers and we’ve looked at some charts, but I like to be really confident when I come up with an investment plan. 

With that in mind, I have one chart left to show you.  When I saw this, and plugged the numbers in, I was very excited with the results considering their consistency with the results we just formulated.

Here is a chart of the USD index/WTIC spread:

You can see the growth in the spread here, and also the thoughts this thing got a little over done and was due for a correction.  With support failure at the 50 day MA, we can expect this spread, which is still bullish fundamentally, to find support just above the 200 day MA. 

Our earlier analysis told us that the USD index is going to rally and top out at 74 giving us a oil price of $112 /barrel.  Those numbers give us a ratio of 1.51.

Although this was a few more charts than usual, I’m glad you bore through it with me, because you can’t put a price on data like this.  We intertwined a couple of forms of technical analysis, in an attempt to help map out the path for crude oil.  Our different techniques gave us consistent results reaffirming our numbers.  This doesn’t mean that we will go strait to our defined support and resistance levels in a couple of weeks before turning the markets.  It will be choppy trading that get’s us there, but to understand this market is to have an advantage trading commodities, equities, and forex alike. 

Nicholas Jones
Analyst, Bourbon & Bayonets