Is Now The Time To Short Oil?

By Casey Murphy | August 07, 2014 AAA

To the delight of most summer travelers, oil prices have fallen 4.93% over the past month, which in turn has resulted in reduced pressure at the gas pump. As you can see from the chart below, the bullish attempt to send prices higher in July failed when the price neared the resistance of the 200-day moving average.

From a trading perspective, this lower high defined the right-most shoulder of the famous head-and-shoulders pattern, which has been used by traders over the past couple of weeks as a signal of a move lower. As key indicators such as the Relative Strength Index and full stochastics near oversold territory, it's not surprising to see short-term bounces. However, traders will expect the price to face resistance from the combination of the 200-day moving average and the neckline of the pattern (99.80).

We’ll take a closer look at an exchange traded fund that is used by traders to track oil prices as well as major companies to see if the entire sector is due for a correction. (For more, see: How To Trade The Head And Shoulders Pattern.)

United States Oil Fund (USO)

Unsurprisingly, you’ll find the same head-and-shoulders pattern developing on the chart of USO. This ETF is commonly used by traders for trading changes in the spot price of light, sweet crude oil. The $37.80 level has acted as a very strong level of resistance, which will likely be used traders to protect their short positions. It is interesting to note that recent price action has found support near the 200-day moving average. The recent strength and accompanying bounce suggests that a move toward the resistance is likely. Bearish traders will likely add to their positions near the horizontal trendline and those with a stronger tolerance from risk will likely only exit a position when the price moves above the 50-day moving average (blue line). (For more on this topic, see: Moving Averages Tutorial.)

Uptrend in Giant Oil Companies

When taking a look at the chart of Exxon Mobil Corp. (XOM) as a gauge for the giant oil companies, it's apparent that it's trading within a strongly define uptrend. The company recently released its most recent quarterly earnings and reported the lowest level of global oil production since 2009. The global increase in oil production as a result of hydraulic fracturing has put a cap on price increases because of increasing supply. In addition, it is becoming more expensive for companies to compete in this area and to develop fields that will significantly add to their bottom lines. These two factors could be enough of a fundamental head wind that it causes the recent price declines to become more severe.  Active traders will use a drop below the ascending trendline, shown by the dotted blue line, as a sell signal and confirmation of a trend reversal. (For related reading, see: ExxonMobil's Massive and Reliable Money Machine.)

The Bottom Line

Weakness shown on the chart of oil prices and oil-related companies is suggesting that a correction is on the way. As shown above, the clearly identified head-and-shoulders pattern on the spot price of oil could start to impact margins at the big oil companies. In addition, lower production levels, combined with increased supply and competition, could be enough of a fundamental headwind that traders will use as a signal to send the prices of the mentioned assets below their last levels of support shown by the 200-day moving averages and long-term trendlines. Closes below these levels will be a clear signal of a long-term move lower. (For further reading, see: Why The Price of Crude Oil is Dropping.)

At the time of writing, the author did not own any shares of companies mentioned in this article.

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