Trimming back Gold long

A year ago I posted that gold was looking bullish. Since then price has rallied about 25-30%. I'm cutting back a large portion of my position because I think the market could see a pullback soon.

On the weekly chart above, note how price exploded higher after breaking out of the ending diagonal pattern. This is just the behavior I was looking for. However, price is reaching $1400 which is the top of the ending diagonal and I would expect there to be some significant resistance here.

The more concerning problem is that commercial traders clearly think that gold prices are reaching overbought levels and they're hedging themselves more than at any point in the past 16 years. 

However, I don't think the bull market is over. I think we'll see a lull or correction for some time as commercial traders unwind their hedges. Then, once COT levels are more normalized, we could see higher prices.

The case for a gold rally

Gold is looking bullish.

The chart above is 10yr chart with monthly candles. Note that price is sitting on strong support – an ascending trendline and a previous high. Also notice that volume has tapered off substantially in the past 1-2 years, a good sign indicating that selling pressure is waning.

The next chart, a 5yr weekly chart, shows that gold is completing wave-5 of an ending diagonal. Historically, these patterns are terminal and are followed by an explosive move in the opposite direction. Wave-3 of the ending diagonal should never be the shortest wave; thus Wave-5 should go no further than 1050, or else the pattern is invalid.

  Finally, note that commercial traders are more net-long now than at any point in the past 10 years!

Combining all the evidence above with the bullish seasonality factor of August, I feel comfortable buying gold at these levels with a stop below 1050.

Natural Gas as a Substitute for Oil?

I recently read an interesting post by Carl Futia which explained why he thought that Crude Oil would soon drop in price. Part of his thesis was based on the fact that Oil is a commodity, and thus has substitutes (namely, natural gas). This piqued my interest, because at first glance, I hadn’t made the connection that oil could be substituted for NG; after all, you can’t just pump up your car with NG!

After some research, however, I agree with Futia’s assertion that NG can substitute a significant portion of energy consumption, which will cause oil prices to drop, and natural gas prices to rise. To explain this dynamic, I’ll start by showing the extent to which NG can be substituted for oil. Then, I’ll show how a small change in supply/demand for a commodity can have a large effect on price. Finally, I’ll highlight whether the market would agree with my assessment.

 

Can Natural Gas be Substituted for Crude Oil?

This web site has a very effective graphical representation of energy consumption in the US (which I’ll use as a proxy for the OECD countries’ consumption pattern). From that chart, you’ll notice that Industrial uses of energy account for approximately 1/3 of total energy consumption (21.8 Q BTU out of 68.5 Q BTU). Furthermore, Industry sources its energy equally from petroleum (oil, 35.7%) and natural gas (34.8%). Because most industrial uses of energy require heat energy (whether it be for smelting or generating electricity), petroleum and natural gas can be interchanged effectively. This is in stark comparison to transportation, in which the prevalent internal combustion engine infrastructure disallows substitution of fuels.

Based on these numbers, there exists a significant potential to substitute NG for petroleum as an energy source. A back-of-the envelope calculation suggests that global petroleum demand could drop by 1m BBL/day if the percentage of petroleum used for industry dropped to 30%, and NG rose to 39%. The question, thus, is whether a 1m BBL/day drop is significant enough to affect prices.

 

How dramatically do oil prices react to changes in demand?

To answer this question, we can look at what happened in the last economic downturn. Due to the Great Recession, Global oil demand dropped from a peak of 86.2m bbl/day in 2007 to 84.4m bbl/day in 2009, and drop of 1.8m bbl/day. As we all know, during this time, oil prices dropped from a high of $147/bbl to $35/bbl. Clearly, a nominally small decline in demand can have a large effect on prices.

Since the potential exists for crude oil to be substituted by natural gas in a significant way, one must only look at price differential to see if Industrial users can benefit from switching. Currently, crude oil trades near its record highs, at $100/bbl, while natural gas is trading near 10-year lows of $4/1000-CF. These extremes in price should offer enough incentive to trigger substitution in a significant way.

 

What does the market think?

The two charts show the price history for the past three years for Crude Oil (top) and Natural Gas (bottom). The bottom pane on each chart highlights the Commitment of Traders data. Notice that commercial traders are holding their largest net-short position in crude and their largest net-long position in natural gas in the past three years. Crude producers are rapidly locking in high prices and natural gas users are locking in low prices. It appears that they also believe that natural gas will soon begin substituting crude oil for energy needs, which will push up prices.

We’ve seen that there is a significant potential for natural gas to substitute crude oil in industrial applications, which would reduce oil demand. We’ve also seen that relatively small change in demand can cause large price fluctuations, and we’ve seen that the current pricing for these commodities supports a trend of switching from crude oil to natural gas. Finally, market participants are revealing that they too agree with this thesis. Natural gas seems like an intelligent investment at this point.

Natural Gas (UNG) Update

Last October, I went long UNG because of a completed Elliot Wave pattern. Since then, there has been a bit of upside progress, but I believe the market is setting up for a much bigger move to come soon.

Notice in the chart above that price did bottom out shortly after I suggested going long. However, the rally has been rather shallow. What strikes me as bullish is that there have been several sharp attempts to make new lows during the past few months, but each selloff was bought, which indicates a lack of overall supply (basing action).

We are currently at trendline resistance, but I believe that because the COT data shows commercial traders holding their largest long position in months, price will ultimately break higher. My target is $12 on UNG.

Trading in EUR/CHF for USD/CHF

Today we arrived at two conclusions: 1) EUR/USD looks bearish. 2) we still like EUR/CHF bullish as discussed a few weeks ago. Thus, we wanted to trade both currency pairs. Of course, we quickly realized that EUR/USD short and EUR/CHF long is the same as trading USD/CHF long. So we did some analysis, and we’re now quite confident in trading USD/CHF long. We’ve switched our EUR/CHF long position to USD/CHF long position.

The chart above (EUR/CHF daily chart) identifies why we were happy to switch out of EUR/CHF long. Notice that the pair bounced of 1.28 as expected, with nice MACD divergence. However, it is testing strong resistance, and just broke an ascending trendline, so it may be under pressure for some time.

The next chart (above) shows why we think EUR/USD is bearish. According to the Elliot wave count, the declines from 1.60 have been impulsive (5-waves) and the rallies have been corrective (in three waves). Currently, it looks like EUR/USD is completing a 3-wave rally to correct the drop from 1.50 to 1.18.

Thus, since we generally like EUR/CHF long, and EUR/USD short, we want to go USD/CHF long:

 

The 15-yr monthly chart for USD/CHF (above) looks rather bullish. First, notice that a 5-wave decline is nearly complete, which indicates a strong counter-trend rally ahead (multi-year). Second, you can see that price is holding at a very strong, long-term trendline (we believe this line will hold, so if price closes below this line on two monthly candles, we will exit the position). Third, Wave-3 ended with a parabolic move. Then, the currency pair went on to retest the parabolic low twice, but so far has not broken it substantially. We think this is quite bullish. Fourth, notice the MACD divergence that could be potentially forming.

Zooming in on the USD/CHF chart (3y weekly chart above), you can see that Wave-5 has formed inside a channel that very closely resembles an ending diagonal, which indicates strong reversal ahead.

While the technicals appear strong for USD/CHF long, the COT data also supports this notion:

First, notice that the 78-week index for Commercial traders of USD are nearing the 100 percentile mark, meaning commercial traders are becoming very net long.

Swiss franc commercial traders are very close to the 0 percentile mark, indicating that they are very, very net short.

Overall, it is a bit frightening to go long USD/CHF when it’s in such a clear downtrend. However, the technicals indicate that it is nearing support, and the COT data shows that we’re taking on the same position as the smart money commercial traders.

Our trade plan is to exit at a loss if USD/CHF closes below the monthly trendline described above for two monthly candles. Our initial upside target is 1.05, and then 1.15.

Fool’s Gold?

Once again, I’m talking about Gold. A few months ago, I was expecting a sharp drop, which did occur. However, the subsequent bounce has been stronger than I expected. I still believe that gold will weaken soon, and if it does make a marginal new high, it won’t be sustained very long.

In the first chart above, the 3y weekly chart, notice that gold broke a multi-year supporting trendline, and is not in the process of retesting this trendline from below. Second, notice the MACD divergence that has not yet fully resolved. Third, notice that in every other major rally prior to latest one, volume expanded heavily on the upswings. This time, volume is absolutely meager, which indicates that buyers are not nearly as confident as they were in the previous rallies.

Next, take a look at the COT data for Gold. The chart above shows gold’s price in the upper panel, and the 78-week COT commercial trader’s index in the lower panel. When the blue line is at 0, commercial traders are more short than they have been in the past 78 weeks, and vice versa for when the line is near 100. With the recent rally, commercial traders have taken the opportunity to drastically increase their short positions, which is a bearish sign.

Finally, I want to comment on sentiment. Seasonally speaking, August and September are quite bullish for gold. However, because this tendency has been so apparent in the past couple years, there is now a general consensus that gold will continue to rally in the coming weeks and months. Combining this bullish sentiment with the bearish factors mentioned above tells me that the probability of a drop is higher than the probability of a rally, and I am positioning myself accordingly. Good luck!