Friday, January 2, 2015

The crude oil "crash"

Crude oil began a steep decline in mid-June that has cut the price in half, and then some.

Consumers see the move as the beginning of a new golden age of cheap energy, an anteroom to Utopia.

Companies that earn their living finding, refining and delivering the sticky stuffy, and traders with bull positions in their stocks, see the decline as a disruptive force that threatens to leave a major sector in the economy collapsed into smoking ruins, a bargain-priced Armageddon.

Adam Smith, I'm quite sure, would enjoy the narrow self interest that guides the rhetoric.

When faced with The End Of The World As We Know It, be it Utopia or Doom, I turn to the ideas of the 20th century French historian Fernand Braudel.

Braudel and others within the Annales School divided the writing of history into three levels: courte durée, also called histoire événementielle, conjonctures, and the longue durée.

In those moments when we're not trying to impress our friends, we would call it the short span, or the history of events, the circumstances, and the long span.

The short span covers the headlines above our news stories, the punditry on our cable networks and the solemn pronunciations of our politicians, the sorts of events that the world is excited about for a day or a week or even a month before it fades into memory. The Obama administration's efforts to focus on economic recovery and jobs, and the Congressional Republicans' efforts to avoid tax increases and reduce government spending fit into this category.

The long term is the geologic time of our lives, the changes so slow that they provide the assumptions behind our existences. The rise of capitalism and liberal democracy beginning in the 18th century might be an example. The long term is largely beyond the reach of policy.

The things in between are covered by the least explicit of Braudel's terms: Circumstances, or the conjonctures. Think of it the trends of years and perhaps a few decades that define eras and yet are within the reach of policy, such as the decline of middle class incomes in the capitalist democracies since the 1970s.

Stocks, their traders and their analytical tools tend to collapse time into a relentless now. Yet market analysis is an exercise in historiography, and Braudel's levels apply just as surely to the markets as they do to the Great War of 1914-1917 and its aftermath.

This 20-year chart of light sweet crude oil futures is, in my mind, a slice of the conjonture level of analysis. With my charting software, 20 years is the longest period available. After all, I'm sure the reasoning goes, why would anyone want to go longer?

Click on chart to enlarge.
Light sweet crude oil futures, 20 years, monthly bars
Crude peaked in July 2008 at $147.22, subsequently declining to $33.32 in January 2009, recovering part of the loss with a rise to $115.83 in May 2011, pausing with a three-year triangle pattern in a sideways trend, and then crashing, as some call it, in the present decline that has carried the price down to about $53.

Prior to the peak, crude had risen from at least $10.65 on December 1998 in a decade-long journey. I say "at least" because I have only a 20-year window; I can't say with certainty when the rise to 2008 began.

One benefit of the context provided by the conjonctures view is that it becomes readily apparent that the decline so far isn't much of a decline.

In the context of the fall from the peak, the price must break below $33.20 before I'll consider it to be in a downtrend. In other words, it must set a lower low.

In the broader context that considers the 2008 peak to be a stop in the journey rather than a destination, I would require the price to fall below at least $10.65 before I would consider the decline to be significant in terms of trend.

How likely is a decline of such magnitudes? It is a classic question in trading: How low can it go?

No one knows the future, of course. For insight, but not certainty, I turn to Elliott wave analysis, whose 20th-century inventor, Robert N. Elliott, had a bit of Braudel in his heart.

Under Elliott, if the decline is a counter-trend correction from the 2008 peak, it would normally come in three waves designated by letters. My count shows crude to be in the final wave, the C-wave, of that move. It can be expected to move below the end of the A wave, $33.20, if the correction is in the form of what Elliott called a Zig-Zag, or to end at about that level if it is a Flat.

Sometimes the three-wave patterns come in groups of three, so the correction could go on for some time, but eventually it will end and the price will rise back above the the $147.27 level as the larger-scale uptrend continues.

However, our 20-year window gives a fragmentary picture. It is also possible that the decline is the beginning of a new downtrend. In that case, the dominant pattern will be five-wave movements, designated by numbers.

If the latter case applies, then the A wave on my chart is actually wave 1, the B wave is wave 2 and the present C wave is wave 3, which can be expected to break below $33.32, perhaps quite far below. There is no way under Elliott to say how low it could go in that case.

To understand the nature of the trend, I need a larger window. Happily, the public domain imagery on Wikimedia comes to the rescue.

Crude oil price history from 1861-2006, dollars per barrel
For this long a period, I'll be looking at the inflation-adjusted dollar figures, on the orange line.

The chart shows a peak in the mid-1860s at about $100, followed by a century of decline to a low below $20 in the early 1970s. Clearly, crude was in a downtrend during that period.

From the early 1970s, crude prices rose to a peak above $80 in the late 1970s, declined again to the 1998 low, which is $14 in 2008 dollars, and then began the rise to the 2008 peak of $111 in 2008 dollars.

By my Elliott wave count, the end in the late 1960s of the decline from the 1860s marks the beginning of a new uptrend, with the 1970s peak being the end of wave 1, the 1998 low being the end of wave 2 and the 2008 peak being the end of wave 3.

Given the fractal nature of Elliott waves, the three waves might well be subcomponents within a larger-level wave 1 working its way higher over a very large span of time.

With that count the present decline is wave 4. The 2nd wave was a directional Zig-Zag, and so wave 4 is more likely to be a sideways Flat.

A 50% correction would be reasonable in such a case,  the price decline has already exceeded that retracement, and so the decline may well  be at or near its end.

That's a lot of assumptions, and so the likelihood that it is correct is fairly low. On the other hand, it is far from being beyond the realm of probability. Time, as always, will tell.

I've marked the current dollars adjusted for inflation, called "2008 dollars", on the 20-year chart. It shows that the decline only today broke below the 2011 low of $74.95 in current dollars, or $71.74 in 2008 dollars.

In other words, take inflation out of the equation, and the "crash" has only now begun and hasn't travelled far enough yet to amount to more than a gentle nudge, barely visible on the chart.

As a trader I live in the short term as I construct my positions and assess the odds and risk/reward ratios. My ideal position has a lifespan of no more than three weeks. I trade in Braudel's histoire événementielle.

But in assessing trends, I look at the conjoncture, and if the data is available, at the longue durée. Traders who ignore the broader sweeps of history are likely to misunderstand the present, which leads to bad trades.

(See the companion essay "Crude Oil and the Black Swan", posted Jan. 3.)

-- Tim Bovee, Portland, Oregon, Jan. 2, 2015


My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.


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Image licensing: Crude oil price history from 1861-2006, dollars per barrel

Created by Michael Ströck, 2006. Released under the GFDL.
Date30 March 2006 (original upload date)
SourceOriginally from en.wikipedia; description page is/was here.
AuthorOriginal uploader was Mstroeck at en.wikipedia
(Reusing this file)
Licensed under the GFDL by the author; Released under the GNU Free Documentation License.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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