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July 23, 2006

An Internal Look at the Oil and Gas Stocks
by Clif Droke

With speculative interest in the oil and gas stocks running high and with many oil and gas companies due to release second quarter earnings, many traders and investors are wondering what the coming weeks and months will hold for the energy group. Another consideration is the coming 4-year cycle, due to bottom around September 1, and the possible impact it could have on prices. In this article we'll examine some important factors as they relate to oil and gas stock prices, including the fuel prices themselves, and hopefully gain some insight on what the future may hold for this group.

Let's start with a look at the most important of the factors influencing the oil and gas stocks right now, namely the upcoming 4-year/8-year cycle bottom. The 4-year cycle is dominant in most major stock market sectors and it has shown its appearance in the oil stock sector in the past. The previous 4-year cycle and 8-year cycle bottoms have exerted some downward pressure against the oil stocks even in years when the group was in a broad upward trend. The previous 8-year cycle bottom of 1998 saw the Amex Oil Index (XOI) fall from its May high of around 500 to the cycle bottom low of 390 in September.

In 2002 when the last 4-year cycle bottomed concurrent with the 12-year cycle it produced a rather pronounced decline in the month of July through the cycle bottom in October. That year was a bear market year, however, and explains much of the downward tendency of XOI in 2002.

Currently the XOI oil index is testing a major all-time high and from chart appearances looks like it wants to break out above it to a higher level. Yet appearances can sometimes be deceiving, which is why it's important to take a look at what's happening beneath the surface. The Amex Natural Gas Index (XNG) recently made a lower high in comparison with the XOI, which has recently made a high equal to its previous peak from June. Historically, whenever the natural gas stocks (reflected by the XNG index) diverge from the oil stocks as represented by XOI, it warns of a coming reaction move in the oil stocks.

To take one prominent example, the last time a major negative divergence was signaled in the XNG index was in earlier 2001. At that time the XOI oil stock index was showing an upward bias and made higher highs through May of that year. During the months of March-May 2001, however, the XNG natural gas stock index made a conspicuously lower high. By the end of May after the negative divergence signal had been flashed in XNG, both the XNG and XOI indices started a decline that lasted until the end of September that year.

Another example of an oil/gas stock price divergence was in 2002 when in July through November the oil industry stocks (XOI) made a series of lower highs and lower lows while the natural gas stocks (XNG) made higher highs and higher lows. This gave advance notice of the coming upside move in the oil stocks in the months that followed beginning in early 2003.

This time around, however, the divergence in XNG is a negative one when compared with XOI. This negative divergence can also be seen much more clearly by comparing the charts of the natural gas futures with oil futures. The natural gas price has lagged the oil price trend for months now and has drastically underperformed compared with oil. In the past such divergences have been followed by one of two things: a. either a strong rally in natural gas (and natural gas stocks) to bring the two price closer into line; or, b. a reversal in the oil price to drag the oil price (and oil stocks) down to purge the speculative excess.

The question now confronting investors is which of these two possible scenarios is the more likely to transpire? If we look even deeper under the surface we see that while the XNG natural gas stock index has already had a noticeable pullback from its recent high, the XNG price oscillators are actually still reflecting a somewhat "overbought" internal condition. This is especially true of the important 20-day price oscillator for the XNG, which is in a level that suggests more correction is needed for the natural gas stocks to remove even more of the speculative "froth" that has built up this year.

That suggests that the oil stock group is the most likely candidate for a correction soon since a fresh natural gas stock rally seems unlikely in view of the current internal readings. There is no denying that the actively traded oil stocks have built a tremendous amount of longer-term upward momentum behind them that will not be dissipated soon or easily. But what of the short-to-intermediate-term? Even in the near term there is some lingering upward momentum in the oil stocks and this can clearly be seen in the fact that XOI is hovering so close to its recent high rather than experiencing a deep pullback (as other sectors have done recently).

One of the best ways of looking at a stock sector's internal momentum is to construct a series of oscillators based, not on price, but on the number of stocks within the group making new highs and lows. With this internal momentum approach you can see even better than standard price-based oscillators the momentum of buying and selling as it exists in a give stock group. One of the prime internal momentum indicators in the near term for showing directional bias is the 30-day rate of change indicator of the cumulative new highs/new lows. This is shown in the chart below as the purple line and the one that is rising.

Yet the more important 60-day indicator (green line), which measured interim upward or downward bias, is downward sloping for the oil stock group as you can see in the above chart. Moreover, both the 30-day and 60-day indicators are in negative territory with the 60-day line having just recently descended into negative territory for the first time this year. That's not a positive backdrop for the oil stocks to launch a major rally from, so it decreases the chances that the oil stocks will commence another sustainable upside move without first making some needed internal "corrections."

With these internal indicators taken from the oil and natural gas sectors, not to mention the negative divergence currently displayed in natural gas and gas stocks, it points to the possibility of a pullback or perhaps a prolonged lateral consolidation in the oil stocks. Ideally it would take some of the pressure away from the consumer fuel prices that are so much a cause for concern among many producers and consumers. The previous 8-year cycle bottom back in 1998 gave us $10/barrel oil and $1/gallon gasoline. Such extremely low prices aren't possible this time around but even a minor drop in the oil and gas price would go a long way toward relieving tensions and would most certainly be welcomed by most Americans.

Clif Droke
ClifDroke.com

Clif Droke is the editor of the daily Gold & Silver Stock Report. Published daily since 2002, the report provides forecasts and analysis of the leading gold, silver, uranium and energy stocks from a short-term technical standpoint. He is also the author of numerous books, including'How to Read Chart Patterns for Greater Profits.' For more information visit www.clifdroke.com.

Copyright © 2003-2008 Clif Droke

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