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Is oil turning bearish?

07 February 2008

The Macro Trader’s view:
The Oil market has been bullish for several years, indeed the Iraq war virtually marks the start of the long Bull Run. But over recent weeks sentiment has turned and so too has the price action.

The economic dynamics driving the oil market have changed quite apart from the geopolitical concerns centred on the Middle East (particularly Iran) which remain to be resolved.

After a period of almost synchronous global economic expansion, led at varying periods by the US and China which produced a global growth rate of around 5.0% for the last 4-5 years, the US economy has materially slowed and the process appears to be accelerating with a recession now almost universally expected.

The drop in US economic activity will depress demand for oil and other energy sources and anticipation of this has began to send the oil price lower.

But there is another side to the story: the Chinese economy is expected to grow at a slower pace too albeit nowhere near as dramatic a reduction as in the US. Nevertheless, any fall in Chinese energy consumption will also weigh on the oil price.

The sums are clear: the US economy at approximately US13.0T is by far the largest in the world and although it only grew at 2.2% last year, that is still a serious contribution to world growth.

The Chinese economy at around US$3.0T is obviously stronger, but with a recent growth rate at 11.0%, its contribution rivals that of the US. Now they are both expected to record weaker growth rates.

1. In the US 0.0% or less - meaning recession, and
2. In China 9.0% - still strong but a clear reduction.

Demand for oil will reduce and oil prices should fall. Although OPEC and Russia have become addicted to the higher oil prices and in recent years have manipulated output to sustain prices, this doesn’t now look like a realistic option.

If OPEC cuts prices in an attempt to support growth, they will simply aggravate the economic slowdown and prices will still fall. It is in their own interests to work with the industrialized countries and allow oil prices to find their own level which will help to stabilize consumer demand and support economic activity.

But that is the end game, we are at the start of the process and recent oil price declines look likely to gather pace, reaching levels not seen over recent years.

The Technical Trader’s view:
Monthly Futures Continuation Chart

The market’s long bull run is clear.

The breakout level to the upside was around $40.

The medium-term test of the strength of the bull trend is the horizontal from the prior High at $78.40.

Look closer.

Weekly bar chart:
The market has been trading between $85 and $100 for the last three months.

Note well the coincidence of supports at the $80 level in the medium-term chart.

Daily Bar chart
The structure within the trading range is a possible - rather imperfect - Head and Shoulders Top.

That pattern completes on a breakdown through the potential Neckline at $85.65.

If that broke we would expect a push down to test the supports at $80.

So the bear case is tightly circumscribed – but clear.

Mark Sturdy
John Lewis
Seven Days Ahead

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