What If Oil Prices Crash?

by Serge Berger | March 21, 2012 8:54 am

As part of my risk management techniques, I always try to envision the scenario where I am 100% wrong in my analysis, and how I would react to that.

I currently have a long position in oil with a medium-term time frame (I call it Bucket 2), and while I see many things supportive of this trade, what might happen if oil quickly falls — say, by $20?

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First off, just for some perspective, look at the chart of crude oil and note that since breaking out of longer-term resistance back in February, the commodity essentially has consolidated. Both lateral support as well as the oscillators (slow stochastics) still look healthy and are supportive of further upside.

Just to play devil’s advocate, let’s assume for a moment that oil drops sharply into the mid-$80s. From a technical point of view, the chart would be broken as the commodity would have undercut the reaction low near $92.75 from Dec. 19. Note that Dec. 19 also was (not so coincidentally) the start of the latest stock market rally. I would be stopped out of the trade because my stops range from $101 up to $103.

How about other sectors in the stock market? Which ones would present us with opportunity both long or short?

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Traditionally, the most sensitive to higher oil prices are airlines, specialty retail and transportation stocks. It’s not rocket science. But let’s look at a 10-year weekly chart comparing crude oil with transportation stocks (NYSE:IYT[1]). The broader takeaway is that, in the near term, there is a tendency for an inverse relationship (oil up means transports down), but viewed with a longer time horizon, they surprisingly move together.

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Net beneficiaries of higher oil prices are oil services stocks. Again, a very simple but effective chart compares the price of oil versus the Oil Services HOLDRS ETF (NYSE:OIH[2]). The positive correlation is obvious.

From a sector or stock allocation point of view, a sharp drop in oil might — in the near term — benefit transportation stocks. The bigger question we would need to ask in the event of an oil plunge, however, is what caused the drop in prices. Was it news related to OPEC or a slowdown in the economy?

Many market participants are often too quick to see lower oil prices as a positive for the economy but forget that it also might be telling us something about the lack of demand for oil in the economy.

Serge Berger is the head trader and investment strategist for The Steady Trader[3]. Sign up for his free weekly newsletter[4].

  1. IYT: http://studio-5.financialcontent.com/investplace/quote?Symbol=IYT
  2. OIH: http://studio-5.financialcontent.com/investplace/quote?Symbol=OIH
  3. The Steady Trader: http://thesteadytrader.com/
  4. free weekly newsletter: http://thesteadytrader.com/archive/

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