OIL MAY BE CLOSE TO AN OCTOBER TOP -- BUT $40 MAY BE NEW FLOOR -- OIL STOCKS ARE OVERBOUGHT BUT IN SOLID UPTRENDS

HISTORY OF OCTOBER TOPS... Late last week I mentioned that crude oil had a history of peaking during October or at least experiencing significant pullbacks. Chart 1 shows the track record. The monthly bars plot the history since 1990. The black arrows show those years where a sigificant pullback occurred during October. My work shows nine October declines out of the last twelve years. In some cases, the month of October marked major tops. In others, an October pullback was just an interruption in an ongoing uptrend. But the record is too consistent to ignore. There are at least two immediate implications of the October record. The first is that crude is nearing a short to intermediate-term top which could materialize during October. The second is that a drop in oil might give a boost to the stock market, which has a history of forming October bottoms.

Chart 1

OIL MAY STALL AT $50, BUT WON'T DROP UNDER $40... The weekly oil chart carries a mixed message. The first message is that the major trend of oil is still up. The presence of potential resistance near $50 -- and seasonal considerations -- suggest that a pullback is due (probably during October). That's the good news. The bad news is that oil probably won't fall below $40. Part of the reason for that view is shown in Chart 2. Earlier this year, oil broke through its early 2003 peak at $40. In chart analysis, prominent resistance levels once they are broken become significant support levels. And $40 is very prominent. Not only was that the 2003 peak in the price of oil, it was also the 2000 peak the 1990 peak, and the 1980 peak. That being the case, I believe that high oil prices are here to say. Although oil looks over-extended near $50, a decline near $40 would, in my view, represent another buying opportunity for oil and/or oil stocks.

Chart 2

OIL STOCKS OVERBOUGHT, BUT GOOD LONG-TERM ... The chart of the AMEX Oil Index carries a mixed message. The first one is that it's very overbought. The 14-month RSI line is trading over 70 (which is overbought territory) for the first time since 1997 (see circles). That doesn't mean they can't continue higher, but that they're reaching dangerously over-extended levels. An October pullback in oil could cause some profit-taking in oil stocks as well. That's the bad news. The good news is that any significant pullback would represent another buying opportunity in the energy sector. Part of the reasoning is based on a bullish long-term outlook for energy prices. Part is based on relative strength considerations. The XOI/S&P 500 ratio line only turned up during 2000. That followed over a decade of energy underperformance. At its major peak in 1980 at the end of that major commodity boom, oil stocks represented the biggest part of the S&P 500 which was sign of overinvestmtne in the group. Heading into this decade, energy had one of the lowest S&P weightings. That means that investment in the energy sector had reached the lowest point in two decades. With only four years of energy outperformance behind us, the long-term term prospects for the group continue to look promising. Not all energy groups are equal however,

Chart 3

NATURAL GAS INDEX NEARS OLD PEAK-- OIL SERVICE LOOKS CHEAP... While the XOI index (which includes large integrated oil stocks) is at a record high, two other energy indexes aren't. The AMEX Natural Gas Index is nearing a challenge of its early 2001 peak. On a short-term basis, that may be cause for concern. With its 14-month RSI line in overbought territory over 70, the group may stall at that level (at least temporarily). On a longer term basis, however, the odds favor an upside penetration of that old high and a resumption of the major uptrend. Here again, while the short-term picture calls for more caution, the long-term picture looks good. Chart 5 plots the Oil Service Index. Two things are worth noting. One is that the OSX is just now breaking through its 2002 peak. The second is that the OSX is the cheapest of the three energy indexes.

Chart 4

Chart 5

LONG TERM IMPLICATIONS FOR STOCKS AREN'T GOOD ... As far as its impact on the stock market, an October pullback in oil would probably be helpful to the stock market during the fourth quarter. The ability of oil to stay over $40, however, will remain a drag on the stock market and the economy into the foreseeable future, and will probably limit stock market gains during 2005.