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Base-Building: Has Crude Oil (Finally) Hit a Double Bottom?

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March 1, 2016
Building blocks of a double bottom: Has crude oil finally begun to stabilize, and will it support the stock market too?

If you've traded stocks in 2016, some might say you've been trading crude oil futures too. The price of crude oil has taken center stage in recent weeks as nearby NYMEX West Texas Intermediate (WTI) crude oil futures tumbled below the 2008 low and touched the $26 handle.

Since mid-2014, oversupply and sluggish demand have shaved roughly 70% off the price of a barrel of crude oil. The recent drop under the financial crisis low triggered speculation that a bottom, or at least a base, could be forming in crude oil. No doubt, picking bottoms is treacherous in any market cycle, but some analysts are wondering if demand growth and production declines could kick in and stabilize the oil market. And, in turn, could stability in crude oil help investor sentiment in the stock market?

Last week, traders got fresh news that the number of U.S. oil drilling rigs, often viewed as a proxy for industry action overall, declined again. The U.S. oil rig count fell last week by 26 to 413, according to a Baker Hughes report. That marks a roughly 68% decline in total rigs from a peak of 1,609 in October 2014.

Short-Term Holding Pattern?

Recent crude oil price action may be forming a type of base on the daily chart. Front-month crude oil futures carved out a low at $28.76 on January 20 and another similar low at $26.05 on February 11 (see figure 1). Technical traders call this a potential "double bottom" pattern. The intervening high near $34, hit on January 28, marks resistance—the ceiling bulls would need to crack in order to confirm the possible double bottom formation. 

crude oil futures

FIGURE 1: YEAR-TO-DATE CRUDE OIL FUTURES (/CL).

A potential double bottom formed in /CL over the past six weeks with support near $26 and resistance near $34. Chart source: TD Ameritrade’s thinkorswim® platform. Data source: CME. For illustrative purposes only. Past performance does not guarantee future results.

"It does appear that crude oil could be building a base," says JJ Kinahan, chief market strategist at TD Ameritrade. However, he cautioned: "It will be difficult for crude to go rocketing out of this because at the end of the day we still have a glut."

To get a sense of the extent of the recent declines, Sam Stovall, managing director at S&P Global Market Intelligence, pointed to a year-over-year percent change chart of monthly WTI crude oil prices (figure 2). 

standard deviation in crude oil

FIGURE 2: YEAR-OVER-YEAR CHANGE IN WTI CRUDE OIL.

Crude oil recently dropped to, but held at, the minus 2 standard deviation level. Chart source: S&P Global Market Intelligence. Data source: EIA.gov. For illustrative purposes only. Past performance does not guarantee future results.

"It appears that the worst is behind us. There is no guarantee that oil couldn’t drop below the minus 2 standard deviation level, but the odds don’t favor such an additional decline. Also, despite everybody freaking out about a high correlation between the S&P 500 and WTI oil prices, history shows that they have traditionally had a high correlation of about 0.7 versus perfect correlation at 1.0. And it makes sense: if the economy is expanding, there will be higher demand for oil, and thus rising prices for oil," Stovall says.

The Stock Connection

Crude oil has taken the blame for part of the stock market's volatility and weakness so far in 2016. Could stability in crude oil lend some confidence to the stock market? Maybe. "Should oil prices find a bottom fairly soon, from an investor perspective, we could see a sigh of relief," Stovall says. "The concern was that the dramatic decline in crude oil was not just an oversupply issue, but also represented a slowdown in economic growth. It could be a positive sign for stocks if oil prices have finally found a bottom."

As crude oil has stabilized, "We have seen a little more interest in buying stocks recently. If you think things are at good prices, buy small positions," Kinahan says.

Keep an Eye on Crude Oil

Kinahan warns that the emotion and noise around crude oil trading remains high. The markets remain in a period of flux, and crude oil could be vulnerable to several tests of price support during a potential base- and bottom-building period, he says. TD Ameritrade clients can monitor the correlation between the S&P 500 futures and crude oil in the thinkorswim® platform (see figure 3). 

crude oil correlation with S&P 500 futures

FIGURE 3: CRUDE CORRELATION WITH S&P 500 FUTURES.

This chart displays /CL and its correlation with /ES averaged over the last 10 days. To add the Correlation study, log in to the thinkorswim platform and click Charts > right-click on Chart > Studies > Add Study > All Studies > C-D > Correlation. Chart source: TD Ameritrade’s thinkorswim® platform. Data source: CME. Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results. 

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