The Perfect Way to Short Plummeting Oil Stocks

Melvin Pasternak's picture

Tuesday, May 25, 2010 - 10:51am

by Melvin Pasternak

The Deepwater Horizon oil spill in the Gulf of Mexico has been called one of the worst-ever environmental disasters -- and may prove to be perhaps even bigger than the 1989 Exxon Valdez catastrophe.

For more than a month, crews off the Louisiana shore have tried to contain the massive leak, but attempts have so far been unsuccessful. Now, the environmental repercussions are starting to spill over onto Wall Street, with "Big Oil" feeling the impact.

On May 14th, President Obama responded to the disaster by vowing to put an end to the "cozy relationship" the oil industry has developed with regulators. And, with the unwinding of the "risk trade" because of the potential impact of the crisis in Greece on worldwide economic growth, crude oil futures have hit a series of five month lows.

As a result, many energy stocks and exchange-traded funds (ETFs) look technically weak.

I've already identified an energy stock I think will be a great short trade for this week's issue of my premium service, Double-Digit Trading.

However, the HOLDRS Merrill Lynch Market Oil Service (NYSE: OIH) ETF could deliver some nice gains in the coming weeks as it appears particularly technically vulnerable.

OIH is a highly concentrated ETF. Its holdings are comprised of only 16 U.S.-based oil firms that service oil wells, drilling rigs and platforms. The fund's top three holdings are Schlumberger (NYSE: SLB) -- 13.6%, Transocean (NYSE: RIG) -- 13.4% and Halliburton (NYSE: HAL) -- 11.8%. Both Transocean and Halliburton are heavily involved in the recent oil spill disaster.

Transocean operated the drill rig that exploded, causing the leak. It is rumored that Halliburton's poor cementing of the well may have allowed natural gas to escape to the rig's surface, causing the explosion. With news of RIG's and HAL's involvement, analysts have downgraded both companies, slashing their price targets.

Because the OIH fund is highly correlated with RIG's and HAL's performance, the fund itself could sink, as concerns about the disaster continue to build.

Since OIH hit a high of $134.77 in late-April, it has dropped more than -23%, to date. Technically, it could fall much further.

Initial news of the oil spill, combined with the recent "flash crash" caused a break of the fund's major uptrend line, which had formed since its March 2009 bottom. In its fall, OIH violated what should have been a bullish ascending triangle.

Having now formed a minor downtrend line off its April high, OIH is sitting below both the 10- and 30-week moving averages, which are flat and intersect near $119.43 -- several dollars within current prices. The 10-week moving average is on the verge of crossing below the 30-week moving average, a strong technical negative.

The fund has fallen below an initial shelf of support near $110, which extends back to October 2009. Last week, OIH also fell below support at $108, near the lower Bollinger band. New support is not likely to be found until around $96, as marked by the intersection of the lower channel line. This level is an area of historical support, dating back to July 2009. If support at $96 does not hold, the stock may fall to around $86. Major resistance is near $134.

The indicators are bearish. MACD is on a sell signal. The MACD histogram is building in negative territory. Relative Strength Index is in a downtrend. At $39.50, it has dropped below the key 50 level, but is not yet deeply oversold. Stochastics, which is on a sell signal, is approaching oversold levels, but is not there yet.

As long as the oil leak itself and investigation about it continue, I expect the OIH fund to be under pressure. Smart investors could make the best of a bad situation and short the ETF if it falls below support at $96.

Melvin Pasternak does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.