Getting Bullish on Oil and Oil Stocks
By Frank Barbera CMT. January 23, 2007
In my view with Oil prices falling sharply over the last few weeks, a little bit of big picture framing is necessary to put the recent decline in proper context. Simply put, this is a routine Bull Market correction and nothing more. Over the relatively near term, it is still possible that we could continue to face a “fast market” type condition, but the evidence is now starting to build that an important bottom has been seen. Once Crude Oil does complete a final low, in my view, the odds are high that we will see a rather strident recovery with prices likely moving back into the mid-$60’s as summer approaches. Thus, the outlook for Oil from here is not bearish, but bullish, as a recovery should do wonders for the equities in the energy sector. That said, let's take a moment and view the last few months in Crude from an Elliott perspective. In classic Elliott fashion, Oil has fallen in a three-step declining pattern, breaking out as a “5-3-5” declining sequence.
From the high in Crude on July 14th, 2006 at $79.45, the first leg down saw Crude trace out a text-book five wave decline which bottomed on October 4th at $57.75 intra-day. Percentage wise, this down leg labeled Intermediate Wave (A) lopped 27.31% off the high price in Crude Oil.
From the low seen on October 4th, prices then rallied back in what was, once again, a very common pattern, what Elliott termed an “irregular flat.” “Flats” are an A-B-C movement wherein the high of Wave A and the high of Wave C tend to end up in the same price zone. Where an irregular flat is involved, the “B” wave makes a token new low and the “C” wave will often end at a higher high than Wave A. A good example is the DJIA in 1987, which had an Irregular Flat in the Wave 2 position just before prices rolled over into the great crash. Note also that following the crash, prices moved into a textbook fourth wave triangle which in turn produced a classic 5th wave post-triangle thrust and retest of the lows.
Where Crude Oil was involved within the Intermediate Wave (B) irregular flat, which started last October 4th and ended on December 15th, Minor Wave C actually traced out a perfect five wave rising wedge, or diagonal triangle, which was a bearish pattern. Thus, when prices rolled over and broke the low end of the rising wedge line and then threatened the October 31st Minor Wave B lows, the odds were high that a second leg down was getting underway. I realized Crude was getting into big technical trouble after Christmas and noted as much in my first report post-holiday (I took the New Year's week off), stating that Crude could fall to the $51 to $52 range in the GST 1/3/07 report. At the time, it stood at $58.05. A key element in my thinking was the fact that after Christmas, Crude Oil was moving lower despite an attack in Nigeria, and a big inventory “draw” which should have been bullish. When markets are unable to rally in the face of positive news, it is never a good sign. Since then, more history has been written and we find Crude knocking, now bouncing off $50. With a nearly 30% draw-down from the high, many will undoubtedly call this break the beginning of a bear market for Oil.
While a 30% decline could be viewed as a bear market, on a purely price driven basis, what we are more likely seeing is a “high-order” bull market correction. Looking at Oil going back to the 1970’s, we recall that the Arab Oil Embargo’s of 1974 and 1979 pushed Oil prices up from $2.00 to $40.00. That was in the inflationary '70s where Commodities of all kinds were in bull market mode. In the case of Oil, the next 19 years were spent tracing out a large five wave contracting triangle with the Sheik Yamani Oil Collapse of 1986, the Gulf War spike of 1990 and the dis-inflationary >move of 1999 marking some of the key reversal points for Crude. It would be my contention that since the lows of mid-November 2001 at $17.00, Crude Oil has traced out what is essentially Cycle Wave One of a still developing five wave secular bull market. In this first advance, prices moved from the low at $17 in 2001 to the high near $80 in July 2006 for a gain of 370% in five years.
In the next chart, I show the detailed wave structure for Crude Oil which led me to conclude that Oil could be nearing an important peak last July 25th, when I noted the serious momentum divergences present on the Crude Oil chart.
“Looking at the chart of Crude Oil, a bear could argue that Crude Oil has just completed a 5 Wave Advance on the long term chart, with the Weekly RSI failing to confirm the series of higher price highs seen in recent weeks. To prove a bearish case on Crude Oil, the nearby contract would need to close below the rising medium term trendline which will come in at the $75 dollar level using the CSI Perpetual contract, and at around the $70 level using the nearby CME August Contract. Until these levels are convincingly violated, it would be a speculative call to be suggesting an important top in Crude.”
As it happened, Crude did reverse to the downside and without the aid of a global recession (at least not yet). The point here is that once prices did roll over, the tipping point was reached and a corrective process took hold. In my view, a very standard retracement for any commodity in this situation would have been a .382 Fibonacci correction of the entire preceding advance. As can be seen in the chart below, with Crude now converging on the $50 to $45 zone, a standard .382 Fibonacci “give-back” has been achieved.
Instead of a “Bear Market,” it is far more likely that Crude Oil is now completing Primary Wave A of a larger Cycle Wave Two correction. Over the next two years, it is likely that Oil — all things being equal — could trace out a “B” Wave back up across the range toward $80, and then a second “C” wave decline back down to the current $50 zone. That would take the better part of the next 18 to 24 months at which point we could then see Crude Oil begin its next SECULAR advance, Cycle Wave Three to even higher highs. Within Elliott, the “third of the third” is known as the “Point of Recognition,” the epicenter of an enormous advance, and the point where the broad scale “crowd” comprehends some basic driving principle that is under-pinning the price advance. In the case of Oil, I believe the secular advance will hit the ‘Point of Recognition’ sometime around 2010 and the subject of Peak Oil will be front and center on everyone’s lips. Ultimately if the world hits Peak Oil in the next few years, prices could easily spike above $100 and even above $200 dollar per barrel.
There are many reasons why Oil prices could rise to such outwardly unprecedented heights, but chief among them has been the lack of CAPEX spending for new energy and alternate energy fuels over the balance of the last two decades. For the US, which imports nearly 70% of its Oil from foreign sources, this dependency on imported Oil is an Achilles heel and could have far reaching negative implications with regard to the inflation outlook and the outlook for real growth in the US Economy. In reviewing several important Time Cycles, I note that Crude Oil has had a reasonably consistent 5.2 year cycle in place, the half cycle of which was due to bottom in 2006. I believe that cycle is bottoming now, a bit later than normal ,and will soon turn up producing a solid recovery in prices. The next major five year cycle low for Crude (the full cycle low) is due in late 2008 which should be the end of Cycle Wave 2 and the beginning of the Peak Oil surge to above $100.
Of course, the present condition in the Middle East is anything but stable, and with the US moving more military hardware into the region, there is also high risk of an escalation of the Iraq War to include Iran. Where Iran is involved, the variables range so far and so wide that there would be many threats to the Energy infrastructure in the Middle East-Gulf region, and the obvious threat of closing down the shipping lanes through the very narrow Straits of Hormuz. In my view, any escalation of the current War with Iraq spilling over into a conflict with Iran could easily accelerate the process pushing Oil prices to new highs above $100 in very short order. A big wild card to be sure, but with this uncertain age of terrorism and sectarian violence, the price of Oil could be moving up and down like an elevator with a lunatic at the controls.
For now, the remaining risk in Energy appears to be mostly “short term” risk, wherein it is possible that Crude prices may yet retest the low one final time. In the case of the widely followed Energy ETF, the USO Fund (USO) prices have just recently moved up into resistance near the declining 100-hour moving average. At the same time, the 9-hour RSI is failing and diverging negatively against higher highs in price. This suggests that prices could be reaching a point where they may be ready to pull back and retest the recent low at $42 on the USO Fund. That would push nearby Oil back down to its lows in the low $50 area. In my view, such a retest decline would be an outstanding low risk entry point for investors interested in Energy.
Within the Energy sector, perhaps some of the best investment ideas are found in the Energy Service stocks which have recently rallied quite sharply on the heels of a very robust earnings report from bell-weather Schlumberger (SLB). With earnings rising at a nearly 70% rate in the most recent quarterly report, SLB provided top-notch visibility to Wall Street last week in its conference call when it stated that earnings and demand should be rising as far the eye can see. With long term contracts in place, many of the Oil Service companies will show outstanding profit growth even if Oil simply levels out between $50 and $60.
Take a look at the table below which shows a the current 5-year estimated growth rates for a dozen leading Oil Service companies, along with their Forward P/E Ratios and their current PE-to-Growth (PEG) Ratio’s. These stocks are dirt cheap and are not pricing in any of their current backlog of orders. At some point, and that is likely all ready underway, Wall Street will wake up and begin re-rating the valuations for these shares. Among the top leaders, only Halliburton (HAL) and Cooper Cameron (CAM) are currently on my negative watch list. In my view, Halliburton’s involvement with the war in Iraq and possible public back lash against it, lead me to avoid the shares at this time, while Cooper Cameron’s exposure to West Africa where Nigeria is a building powder-keg, and assets could be nationalized, also would point me in a different direction. Among Oil Service companies, all of the companies on the list below have bullish fundamentals wherein company risk is at least more reasonable. Again, just one man’s opinion, but I would also take note that within the OIH, 11% is HAL, again which I am omitting from my holdings. Nevertheless, the point here is that the PEG Ratio’s for the bulk of the sector below 1.00, and in many cases below .50, we are looking at a very under-valued, ground-floor type situation.
|Company||5 Yr Estimated||Forward||Current PEG|
|3||TransOcean Offshore (RIG)||40.30%||10.30||0.64|
|4||Global Santa Fe (GSF)||47.00%||8.02||0.33|
|5||Smith Int'l (SII)||17.00%||13.25||0.93|
|6||Nabors Industies (NBR)||40.00%||6.95||0.20|
|10||Ensco Intl (ESV)||37.20%||7.21||0.27|
|12||Grey Wolf (GW)||22.00%||6.97||0.31|
Source: Yahoo Finance
Finally, I will end with a very long term view of the Oil Service sector. In the chart below, we see an index of leading stocks going all the way back to 1967, a period of 40 years. Technically, the chart has formed a huge “Ascending Triangle” base formation which has just broken out over the last 18 months. The downward action of the last few weeks represents, on a long term basis, a pull back toward the breakout point. These types of very long term base patterns invariably give rise to “Secular,” “Multi-Year” Bull Market moves, which in my view is precisely what is coming next for this group. While the high volatility makes the group “not for the faint of heart,” they are nevertheless under-priced assets that any Graham and Dodd analyst would love; they are the stock market equivalent of a no-brainer holding the promise of outsized investment returns for years to come.
That’s all for now.
© 2007 Frank Barbera