Why Black Gold may Explode in Price
Dr Richard S. Appel
May 28, 2004
This week, crude oil posted a new record high price and approached $42 a barrel. Incredibly, only a few short years ago in late 1998, oil was nudging the $10 level. From that nadir, black gold began its upward march that has placed it at the doorstep of unchartered waters. Now, having broken above its seemingly eternal ceiling, it faces a condition where there are no known areas of resistance that should interfere with a potentially astonishing advance. This likelihood is magnified by the fact that during the past three years, and especially in the last year and a half, it's great volatility has driven all but the most steadfast of bulls out of the market. This has cleared the path for the entrance of an enormous influx of new buyers into the market, when its old high is confidently surmounted.
We have been hearing and reading the prognostications from both pundits and experts alike that oil and gasoline are headed to far loftier prices. Yet few project the potential for a near-term 50% or greater advance, which I now believe has a high level of probability. My only caveat is that oil must first confirm its break-out by remaining above it's old high, which it posted during the Gulf War in 1990, of about $41.25 a barrel for several trading sessions.
Commentators talk about the war in Iraq and the potential for disruptions in the oil supply as the reasons for their higher price projections. This is supported by the damage done to Iraqi and Saudi Arabian pipelines as well as by the deaths of a number of non-Saudi nationals whose purpose was to maintain Saudi oil production. Or, they discuss the great oil thirst emanating from China and the improvement in the world economy. These have combined to pressure crude's supply vs. demand equation. However, the key reason for my projection is simple. It is solely based upon historical commodity price movements which resulted after earlier all-time highs were breached.
The last time that we experienced a number of record commodity highs was in the 1970's. During that period, as one commodity after another broke through the restraining, invisible ceilings that were their earlier peaks, they experienced enormous, explosive price advances. As commodity after commodity soared into new high territory they astounded all onlookers as they quickly ascended not 10% or 20% above their earlier apexes, but 30% to 59% or higher.
In his March, 2004 newsletter Past Present Futures (1158 26th St. #523, Santa Monica, CA 90403-4698), James Flanagan listed the startling results of his extensive historical research of commodity price advances. In his study of the twenty-five most recent commodity price rises, after new highs were posted, he found that seventeen of the twenty-five (68%) increased 30% or more, and that ten of the twenty-five (40%) advanced 59% or more. Even more stunning was the short time-frames in which occurred these enormous price gains. Twenty-one of the twenty-five (84%) lasted 3 months, 18 days or less, and eighteen of the twenty-five (68%) lasted 2 months, 20 days or less. Based upon the precedents that Mr. Flanagan found, if oil can muster sufficient strength to firmly position itself above its all-time high, the world should shortly witness a crude oil price explosion of enormous proportions.
These mind-boggling commodity price rises resulted from what I believe were a confluence of events that accompany a commodity's price movement when it breaks above an established high. They are as follows: First, the commodity had already been in a Bull Market. Supply and demand had become unbalanced which created extremely tight market supplies. Second, prices were bid up by those who used the commodity, the commercials, and by others who recognized and desired to profit from its Bull Market's progress. These players moved the market higher until its price butted up against its earlier historical high. Then, some short-sellers who were overwhelmed by the amount of buying began to realize and accept the existence of the Bull Market. They attempted to exit their positions; they also bought. Or, they may have even reversed course and acquired additional contracts.
When the old high was surpassed new traders, trend players, chartists, the equivalent of our present hedge funds etc., sensed the appearance of the new trend as well as the fear in the actions of the short holders; they smelled blood in the water. They initiated or added to their long positions. Then, as ever more shorts unwound their positions by placing off-setting buy orders, panic set in among the remaining short-sellers. These players had already sustained significant losses due to having bet against the bull trend. They had steadily watched the market move higher and feared further potential devastating damage. They desperately wanted out.
Finally, as prices moved increasingly above the old peak, a new situation transpired. Those who held early long positions were emboldened to make additional purchases. They had already profited significantly from the commodity's advance and they recognized that its price was heading still higher. Additionally, the consumers of the commodity became frightened that they would have to pay sharply higher prices. They made additional purchases to hedge that possibility.
These groups were then joined by the technicians, momentum players and others, who had observed the Bull Market in progress. They finally "pulled the trigger" and, along with the remaining short players who were madly scrambling to exit their positions, they too bought. The end result was an enormous influx of buying which overwhelmed the limited amount of selling. Many of those who might have considered shorting the market were already on the sidelines licking their wounds.
As you can see from the excellent work of Jim Flanagan, the exciting price rises that historically follow new commodity prices records are typically brief in duration. Further, when the run is finally over, the commodity's price is normally substantially above its earlier high. These great price advances end from exhaustion as do all major price movements. The unwinding of this or a similar series of events in the marketplace is nothing new. Indeed, they are based in human nature and are repeated throughout history. They not only occur in commodities, but in stocks, bonds, currencies and any other exchange traded market. However the greatest potential price gains normally accrue to the commodities.
Interestingly, shortly after a record commodity high price is struck, there are frequently initial pullbacks. Thus, it is not unusual for the first thrust above the earlier high to be met with aggressive selling. The longer that an all-time high has been in place, and especially the more times that its penetration was prevented, the greater are the short players mind-sets that it will hold. Then as now, traders knew that all-time peaks have historically been some of the best places to initiate short positions. This is because those price levels had already successfully repelled a commodity's upward progress, and thus the odds favored a repeat performance. Often, these areas create "double tops" from which lower prices ensue.
This knowledge works to the advantage of the bulls because it sets the stage for short-sellers to pile in when an all-time high point is approached or minimally breached. When a great Bull Market is in force, such as I believe that we have across the commodity boards and especially in crude oil and gasoline, the short players find themselves on the wrong side of what is destined to become a major up-wave in progress. If the shorts initially succeed in forcing the commodity's price briefly below its break-out point, they are increasing both their potential losses and the magnitude of the final advance.
This results because their new, aggressive short-selling acts to further coil the spring. It has been tightened due to the supply vs. demand imbalance that has already driven the commodity to record levels. After the commodity's brief decline is exhausted a new wave of buying enters the market, and the short-sellers are trapped. However, due to their gallant effort to again force the commodity lower, the number of shorts that must be reversed has increased.
Oil posted a high of about $41.25 a barrel in 1990. It again rallied to $40 in January, 2003, and approached that level, only to fail posting a new high. To the minds of numerous real and potential short-sellers the $40 to $41.25 range is a confirmed area of great resistance. It is for this reason that we are in the midst of a great battle between those who are aligned, with what I believe is a great secular Bull Market, and those who feel that they can once again turn back the oil tide.
I believe that the stage is set for an explosive rise in the price of oil. All that is needed to light the fuse is for crude oil to hold above its old high for a short period. If this occurs, and if history is a guide, it will quickly find itself in the $55 to $70 price range.
THE U.S. STOCK MARKET
The U.S. stock market continues to be the battleground between two extreme influences. On the positive side, the economy appears to be improving. Yet, few real jobs are being added to the employment roles. Rather, part time and ephemeral ones, jobs that the government believes, but cannot prove exist, have swelled the employment figures.
I believe that the real reason why the market has advanced during the past year and a half, and has exhibited such resistance to decline, is the massive amount of liquidity that the Fed has created. In their frantic effort to reverse our economic weakness the Federal Reserve System has produced an enormous amount of new, potentially inflationary dollar credits. These newly issued dollars had to go somewhere. And, due to the generally held belief that the stock market is the place for savings, and housing prices have been heading skyward for quite some time, much of this money was drawn into these two areas.
On the other side of the coin is the fact that U.S. common stocks entered a secular Bear Market during the summer of 1999. For similar reasons as stated above, the unprecedented amount of Fed generated liquidity has delayed the unfolding of the Bear Market. Common stocks remain greatly overvalued. The S & P 500 continues to be priced at a P.E. ratio of thirty-ish and its dividend yield is two percent. Historical market tops occurred when its P.E. ratio was in the neighborhood of twenty-one and its dividend yield approached and was seldom below three percent.
The struggle between the Fed's desire to keep the economy afloat and the ultimate overwhelming of their efforts by the wrath of the bear, is exhibited best in the machinations of common stocks. When the Fed finally loses the battle, and unless they literally destroy the purchasing power of the dollar, we will experience a severe, long-term decline. That is if they still have sufficient influence to avoid a stock market collapse.
Most investors do not understand what is a real, secular Bull or Bear Market. Briefly stated, they begin at extremes and do not end until the opposite extreme occurs. In the case of a Bull Market, they peak after the market has reached a point of excessive, historical overvaluation. When the Bear Market takes hold it will not be completed until it progress and takes the market down to a level where it offers great values. In the history of the U.S. stock market, great values at Bear Market lows were when, as measured by the S & P 500, dividend yields were about six percent or higher, and the price-earnings ratio was well below ten, and often in the range of seven or eight. This is a far cry from today's lofty levels. Further, Bear Markets have not ended during pleasant times. Business conditions were typically depressed or worse, and earnings were substantially below their earlier highs. Therefore, investors doubly suffered by a combination of lower earnings and a reduced P.E. multiple.
Today, the market is quite oversold which is likely a major reason why it is resisting a decline. On the other hand, many of the internals of the market are quite weak such as the advance-decline line and the increase in new lows over new highs. It remains to be seen when the market will succumb to the bear. For me, I would rather be invested in a major Bull Market such as that which exists in the precious metals universe, and suffer its periodic price declines, than hope, wish and pray that common stocks are really a form of savings, much of which I believe will be eventually lost.
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