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Crude Oil Prices: Possible Bearish Pattern in Oil Futures

Posted November 19, 2007

“The $85 level could provide a little support for oil prices, meaning a bounce. If oil bounces, it will have created a neckline for this larger head-and-shoulders pattern, and a fulfillment of this larger pattern could send oil prices as low as $65 a barrel.” — Sara Nunnally

by S.R. Nunnally, Today’sFinancialNews.com

Baltimore — (TFN): On Friday, as 340,000 December futures contracts held purely by non-commercial market participants expired, we saw the price of oil jump nearly $2. Why?

Well, about 42,000 of those contracts were calls with a strike price of $100 a barrel. If you ask me, those oil futures have got a snowball’s chance in hell of getting in the money. I told CNBC this past Monday that it would be a very volatile week for oil prices, and boy, was I right. Here’s how those December futures moved this week:

Monday, November 12: down $1.70; high of $96.20; low of $93.54
Tuesday, November 13: down $3.45; high of $94.70; low of $90.13
Wednesday, November 14: up $2.92; high of $94.37; low of $91.21
Thursday, November 15: down $0.66; high of $94.64; low of $91.86
Friday, November 16: up $1.67; high of $95.47; low of $93.20 (at 11:40 ET)

Talk about some long candlesticks!

You can see very clearly, though, that today’s movement is due to those non-commercial speculators (hedge funds) trying to get as much out of their contracts as possible. How do we know?

So let’s look at the Energy Information Administration’s number for last week: The EIA reported a rise in oil stocks of 2.8 million barrels. We produced more and imported more. In fact, last week was the first week we’ve seen a rise in inventories in four weeks.

Now, the EIA says that it’s hard to measure the effect hedge funds have on the oil futures market, but one thing’s for sure: Even bullish fundamentals such as our inventories being down 21.3 million barrels of oil from last year shouldn’t be enough to have the spot price of oil $37 higher than this time last year.

That 21.3-million-barrel difference seems like a lot, but last year, our oil stocks were well above the normal range. This year, we’re just about at normal. That means you could probably split the difference of last year’s oil price at this time and this year’s oil price now and arrive at a “fair value” for where oil should be, about $78.01.

So, what could justify a drop from the mid-$90s to the high $70s?

How about a possible head-and-shoulders pattern? Here’s a chart of oil’s January futures.

chart

There are two things worth noting: The left shoulder from mid-October is a good ways down from where oil currently trades. Also, there could be a mini head-and-shoulders formation setting up from today’s little boost in prices.

Let’s start with the mini pattern. Between October 24 through October 29, oil futures were climbing swiftly. Then, on October 30, they dropped more than $3. That’s the left shoulder of the pattern.

Halloween saw oil prices surge back again as the EIA reported a drop of 3.9 million barrels of oil stocks. This movement triggered the formation of the head of the pattern, which eventually topped out on November 7 before rounding over and dropping back to the $90 level on Tuesday.

The right shoulder is just beginning to form in the last three days. Now, in order for this pattern to win out, we should see some strong resistance to higher movement on Monday. I think we’ll get that, and oil prices will start to drop.

The neckline of the head-and-shoulders pattern is just below $90 a barrel. The right shoulder needs to drop below that level in order to confirm this bearish formation.

If it does, we could see a significant drop in oil prices over the next two weeks. Head-and-shoulders patterns drop an average of 22%, So from $90, that means oil could drop to just below $70.

Here’s where things get interesting regarding crude oil prices…

If that mini pattern comes through and oil prices continue to drop below $90, the next level we need to look at is $85. That’s where the larger head-and-shoulders formation becomes very clear.

Remember, I told you that the left shoulder of a head-and-shoulders pattern could be seen in mid-October.

The $85 level could provide a little support for oil prices, meaning a bounce. If oil bounces, it will have created a neckline for this larger head-and-shoulders pattern, and a fulfillment of this larger pattern could send oil prices as low as $65 a barrel.

What does all this technical jargon mean? Let me put it in plain, simple terms. Oil prices could drop in a major way over the next two months. Realistically, just how far? Aside from the bearish patterns I described, I noted earlier that “fair value” for oil could be pegged at $78 a barrel.

Realistically, I think we could see oil prices between $78 and $85 by the end of December.


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Posted by Sara Nunnally · Filed Under Oil and Energy 

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