Expect a new downtrend in Brent crude

WITH the recent news on possible easing of output restrictions in the June Organization of the Petroleum Exporting Countries (Opec) meeting, oil tumbled hard on May 25. WTI and Brent crude oil fell as much as 4.4 per cent and 3.2 per cent respectively. Both Russia and Saudi Arabia mentioned that they are likely to add to production output in H2 2018 to pick up the slack from Venezuela and Iran.

Interestingly, the US$80.00 psychological round number resistance area appeared to be a major roadblock for the bulls for Brent crude oil. There were two major rejections off the US$80.00 round number in May, which led to the current selloff. Thus, we expect the US$80.00 round number to be the immediate top for Brent crude oil and for a new downtrend to begin as the long squeeze unfolds.

Currently, the net speculator positioning in oil futures are still at a record high, suggesting the crowd is still extremely long oil. Historically, the net speculator positioning provides a reliable contrarian signal when the positions are at either extreme.

The masses tend to get it wrong when everyone is betting on the same side. Hence, with the recent selloff in oil, we expect more long speculators to unwind their long trades, and that should in turn result in the long squeeze in oil leading to the start of a new downtrend.

Shifting the attention over to oil stocks also shows a similar topping formation. We will be referencing the Energy Select Sector SPDR ETF (XLE) for this illustration. XLE is an ETF that holds large-cap US energy stocks that develop & produce crude oil and natural gas, provide drilling and other energy-related services.

Both the top line and bottom line of the oil companies are highly dependent on the oil price. Hence, there is a very strong positive correlation between oil price and the oil stocks. Simply put, oil price leads the performance of the oil stocks to a certain extent.

The long-term view of the XLE chart looks bleak with the recent selloff. The area of interest that came into the spotlight was the US$77.51 resistance area. It was first established in October 2014 as support and has since then acted as a ceiling, preventing XLE from breaking above it, shown by the highlighted boxes in the chart.

Another interesting observation was how the XLE tends to mean revert after the Relative Strength Index (RSI) enters into an overbought condition. RSI measures momentum. Any reading above 70 represents an overbought condition while any reading below 30 represents an oversold condition.

The past two times when the RSI was overbought - above 70 - happened with the XLE trading at the key resistance area of US$77.51. Once the bearish price action appeared with the RSI closing back below 70, the mean reversion lower happened, resulting in a -19 per cent and -10 per cent selloff respectively.

The recent price action also shows a similar pattern forming. Even though the RSI failed to enter into overbought condition as XLE broke above the key US$77.51 resistance area on the week ended May 18, the RSI was still at the high side of 67. More importantly, a RSI bearish divergence is forming with the recent sharp selloff in the week ended May 25.

The week ended Jan 12 was when the RSI hit a high of 74 while the XLE hit a high of US$77.62. Fast forward to today, with a strong bearish price action (Bearish Engulfing Bar) rejecting the US$77.51 resistance area, the RSI bearish divergence is confirmed, signalling for a larger move lower.

On the week ended May 18, the RSI formed a Lower High at 67 while the XLE formed a Higher High at US$78.82.

Therefore, with the expectation of a bigger long squeeze happening in the oil complex where the oil price should revert lower, a similar move lower should also happen in the XLE. The current bearish triple top rejection off the critical US$77.51 resistance area and a bearish divergence formation suggest a mean reversion lower for the XLE. For this leg down, expect the XLE to test the US$69.90 support area followed by US$65.65.

Keep a close look out on the further developments in the Opec meeting that is scheduled to happen on June 22. That will be the main catalyst that will drive the near-term move in oil.

Disclaimer: Chartpoint is provided by Phillip Securities Research for information only, and should not be construed as investment advice