You have probably already noticed that oil prices took a dive last week as nuclear treaty talks with Iran in Vienna began to look more promising. The decline reflected the expected impact of an increase of 500,000 barrels of oil flooding the market per day when sanctions are lifted.
Some analysts have suggested that the slide in oil prices is over in the short term because that new production won’t happen until 2016, at the soonest. We believe that this is a situation in which the analysts are not aligned with where traders are putting their money (or not putting their money) and that oil prices are more likely to continue dropping.
As you can see in the chart below, the SPDR Oil Sector ETF (XLE) dropped to support near $72 before bouncing over the last few days. On the surface, this may seem to justify expectations that the new oil production from Iran won’t have a significant impact on prices until later next year. However, what is more likely is that this is merely a technical move off of support as some bearish traders take profits.
How can we tell the difference between the two arguments? Are oil prices safe until 2016, or is this a brief squeeze before prices drop again? In this case, volume or participation may help to differentiate between the two alternatives. This is why we are using an equity-backed index ETF for this analysis, rather than oil futures directly, where the data is a little cloudier.
If traders expect the index to rally, participation will rise as new buyers step in to take the stock from weaker hands. As you can see, in December and January, each new bounce was confirmed by above-average volume levels. Even March’s surprising rally was accompanied by above-average volume on up-days.
Unfortunately, increased participation is not what we are seeing right now. Volume is slightly higher than it was in June, but most of the increase has been on down-days. Without a solid signal that new buyers are stepping into the market, traders should be very skeptical of the potential for a new bounce. Analysts may be confident that oil prices will be unaffected by increased production in 2016, but the market participants that really matter (investors) seem to be harboring some doubt.
From our perspective, there could be a few reasons for lower participation in the current bounce. Uncertainty in Europe (with or without a Greek bailout extension) and declining economic growth rates in North America and China are serious problems for oil prices. Expected increases in production in 2016 could also motivate Russia, Norway, Mexico and the United Kingdom to ramp up production now in order to beat the rush.
Lower oil prices are a mixed blessing. On the one hand, lower energy prices are good for economic growth because manufacturing, transportation and electricity should all be less expensive. However, lower energy prices also depress a major economic sector that has already been hammered since last year’s decline. Declining prices also increase the risk of disinflation/deflation, which makes it more difficult for the Fed to justify a rate hike, and could keep wages low.
We believe that the short-term negatives on the market from lower oil prices outweigh the positives. This means that the channel on the S&P 500 is unlikely to break to the upside and that bulls should be prepared to stop and reverse when resistance comes into play.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
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