Rising Oil Prices: How Much Is Left In The Tank?

Part of what we do is to try to identify emerging trends in the financial markets in their very early stages, and then to determine how long these trends are likely to last. To do this, we use a combination of; 1) technical patterns and price action, 2) inter-market relationships and 3) investor sentiment. Today's blog posting pertains to investor sentiment and how useful it can be, especially when the financial media, the analysts you see on TV, and sometimes your own intuition are leading you down the wrong path.

At the end of April, crude oil prices had just collapsed by almost $9 per barrel (7%) after spiking higher by $20 per barrel (20%) since the beginning of the month. This quick 180 degree turn-around in oil prices resulted in the assumption by many market analysts and financial journalists that oil prices were peaking -- and, at the time, recent price activity made it difficult to argue with them.

However, our investor sentiment data was indicating a completely different story.

In our April 30th Sentiment Survey report (which examines investor sentiment for the US stock market, US interest rates, foreign exchange and economically-sensitive commodities), one of the data series that we were watching closely was our Rydex Energy Ratio. The Rydex Energy Ratio is the total assets invested in the Rydex Energy plus Energy Services Funds divided by the combined total assets invested in all 18 Rydex sector funds. It indicates how much “sector bet money” is being directed to energy-related assets.

Here's the chart from that report, which displays the Select SPDR Energy Sector exchange-traded fund (XLE) in the upper panel and our Rydex Energy Ratio in the lower panel. We note that the XLE has been tightly correlated to both the crude oil contract (CL) and the AMEX Oil Index (XOI) during the past decade, so the prices of all three assets should rise and fall together.

The green and blue highlights in the lower panel of the chart define under- and over-invested extremes in our ratio which, as the color-coded vertical highlights point out, have coincided with most every important near term bottom and top in the XLE since 2005.

The rightmost green vertical highlight shows that, contrary to what one may have logically assumed in late April as the XLE and crude oil prices were plummeting from all-time highs , the Energy Sector was still only about halfway to reaching previous over-invested extremes (from its February lows). These data told us that, at least from an investor sentiment standpoint, there was still more room for energy-related asset prices to continue moving higher before the likelihood of a near term peak came back into play. Since that report, crude oil prices have indeed risen, by almost $16 per barrel (14%), while the XLE has coincidentally risen by 6.68 (9%).

Through Friday's (May 9th) data, our Rydex Energy Ratio is just now starting to close in on those previous "over-invested" extremes (as indicated by the blue highlights in the upper panel of our chart), but is not quite there yet. Once it reaches these previous extremes, it will indicate favorable conditions to start looking for a decline to begin in the XLE, crude oil prices and the XOI.