The energy markets have grown infinitely more complicated in the last 18 months. Contrast this period with the massive rally that began in 2003. Back then, everything went up with crude oil, including explorers, refiners and service stocks. Even lowly natural gas found a strong bid in all the excitement, lifting the forgotten fuel to an all-time high.
The broad sector has turned into a crazy quilt of winners and losers these days. The tug and pull between commodities, equities and currencies has yielded a chaotic mix of price patterns that predict a broad variety of outcomes through 2008. Nowhere is this sibling conflict more potent than with the refining stocks.
Valero Energy
(VLO)
stood out as a top gun in the energy sector during its powerful rally run between 2003 and 2007. The refiner peaked at 78.68 last July after nosing above 12-month resistance, and then rolled over into a moderate decline that expanded into a series of ugly down waves.
The stock bounced at two-year lows about a week ago, but selling pressure has now returned after the company lowered 2008 earnings estimates well below analyst expectations. Short-sellers are licking their chops here because a breakdown at major support near 45 will issue a strong sell signal.
Refining stocks, as a group, have underperformed crude oil by a wide margin for the last nine months. Notably, the trouble began at exactly the same time that crude rallied into the upper 70s and began its historic run up to "round number" 100. It's just mindboggling how these stocks have been unable to profit from skyrocketing fuel prices.
Crude oil is priced in U.S. dollars. The collapse of the greenback has triggered all sorts of arbitrage plays that have forced crude higher with each uptick in the euro. Of course, this relationship has been in force through the entire energy rally, but it's taken on new fury since the euro/dollar broke over 1.50.
Many energy companies can't benefit from a weak dollar, which offers a major reason for the fracturing of stock performance through the sector. But clearly, it isn't the only reason. In addition, energy-related equities tend to follow the stock market during periods of high volatility and the underlying commodities during periods of low volatility.
It took just one selloff day in the energy complex for the boneheaded financial media to declare the end of the crude oil "bubble" and the imminent return to happier days for motorists worldwide. But nothing could be further from the truth. The rally that began five years ago shows no signs of topping out, despite repeated call to the contrary.
Crude oil has doubled in price since last August, but the pattern through the period shows great stability, with a series of pullbacks that have found strong buying interest. Notably, the rally paused below 100 for almost four months before breaking out in late February.
Commodity shakeouts tend to be furious, with prices crashing through support to take out stops and make position holders question their faith. Crude went through one of these volatile periods last week, mainly because the long-side trade got really overcrowded after the 100-buck breakout. But this downturn is unlikely to mark the top for energy complex.
Despite this week's bounce, don't be surprised if crude ultimately breaks 100 and drops to 86, which marked the floor for broad 2007 consolidation pattern. That zone would be a great spot for energy bears to declare victory, and then get their heads handed to them when the instrument shoots back over 100 and into another string of historic highs.
With the stock indices in retreat, energy equities are having a tough time pressing up to new highs, even though crude oil and natural gas are still in rally mode. This is well illustrated in the oil service stocks, which are lagging the commodity markets despite a boom business.
The Oil Services HOLDRs
(OIH)
rallied to a high in the 160s in 2006 and pulled back. It returned to this level 10 months later and broke out. That run carried the fund above 200 last October, where it rolled over with the rest of the equity market. The stock bounced with the major indices in January, but has shown little progress in the last month.
There's no evidence here that oil services stocks are getting ready to recover and charge up to new highs. In fact, the bounce off the January low has been marked by limp accumulation and a failure to stay above the 200-day moving average. The bottom line: This is a group to avoid these days, despite the crude oil rally.
By the way, you're not alone if you think this weekly pattern looks disturbing. The fund is marking out the boundaries for a potential head-and-shoulders topping pattern that might yield far lower prices later this year, and into 2009. But let's not get ahead of ourselves, because a lot could happen between now and then.
At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.
Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
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