Before I get into this, I want to make one thing perfectly clear:
I am NOT bullish on oil.
Shale companies are pumping away as fast as they can to build up as much cash and pay off as much debt before the next big down leg for oil prices comes.
The future for oil is bad.
What you’re seeing now is on par with the early 1980s oil price crash which preceded a 20-year go-where market.
The true bottom for oil prices and oil price stocks will be set when the oil debt markets implode and all these shale oil assets go from weak hands to strong hands for pennies on the dollar.
However, with oil prices depressed and oil stocks pricing in catastrophe, there will be temporary rebounds.
This indicator I’m going to show you today will tell you when those rebounds will come and when to get out as well.
The Ultimate Oil Price Indicator
As you’ve been reading in these pages for well over a year now, there’s no reason to be interested in oil right now.
And if you’re a longtime reader, that’s precisely the reason to actually be interested in oil.
We described this coming situation almost a year ago when oil was “recovering” from the first down leg and everyone was jumping into beaten up oil stocks:
The key [to buying oil is waiting for] the undershoot.
Right now oil seems fairly priced at between $45 and $50 a barrel.
You could make a reasonable case oil prices fall to $35 or $40. And you could do the same that oil prices are going back to $60 or $70.
So the fair value for oil would be somewhere between $35 and $70 a barrel based on marginal production costs, supply and demand, and the thousands of other factors driving oil prices.
The key point to know when it’s finally time to buy in -- and why top investors like [Carl] Icahn expect more carnage to come -- is when an asset undershoots the reasonable fair value range.
At a recent low below $27 a barrel oil is undershooting its long-term price.
Now, think of a rubber band.
The more you stretch it, the more it bounces back when let go.
That’s what oil is now. A stretched rubber band. It will bounce back. And when it does, it will be fast and sharp.
Luckily, there’s a great way to tell if, when, and by how much oil prices will bounce back.
The VIX is a remarkable indicator of when pessimism has reached extreme highs and when stocks are set to bounce back.
Well, there’s also a “VIX” for oil too. It’s called the “Oil VIX” and it works the same way as the VIX for the S&P 500.
It’s basically the cost of “insurance” against further drops in oil and it correlates perfectly with bottoms in oil prices.
Take a look at the oil price chart below:
I’ve highlighted the three major bottoms in oil prices over the last ten years.
Now, take a look at the Oil VIX over the last ten years:
They match almost identically.
The Oil VIX at last week’s levels in the high 60s or higher signals a bottom -- at least a temporary bottom -- in for oil prices.
That’s the level it hit a week ago when oil broke through the $27 a barrel price.
It hit 74 and since has fallen back to the mid-60s.
Now, there are two trades here.
The first is the upswing.
If this oil run has legs, the price of a barrel of oil will likely run to $40 and $50. That would push the Oil VIX down to the mid-20s and many of the most beaten down oil stocks up 50%, 100%, or even more.
That’s quite risky given the long-term price of oil.
The second trade -- and the safer trade -- is to get to the sidelines, wait for this rally to run it’s course, and if and when the Oil Vix falls back down to the mid 20s or 30s, bet against oil all over again.
If you’re lucky enough to know and understand the VIX and the Oil VIX work (or have a Profit Alert Daily subscription), you know you have two low-risk, high-reward trades setting up for you.
In a market where large cap stocks are set to fall more and China is getting worse, that’s not a bad spot to be.