July 1, 2008: Oil has gained increased influence on the equity markets and the price of oil now has an inverse effect on the price of equities. Many pundits have given reasons for the rise of oil including speculation, supply & demand, and a weak dollar. Of course all of them are in play.

The need to look at oil is imperative. Firstly, its rise negatively impacts our equity holdings. Secondly, we also need check if oil makes sense for our portfolio. A rise in oil can act as a good hedge to the falling value of equity holdings.

After careful analysis, we feel that oil is not a good investment now. You should have been on board a long time ago and people with positions on oil should start booking profits. It's possible that oil might go up further, but the downside risks seem higher. We will look at two oil exchange traded funds (ETF)—USO and DBO—to track the oil sector. XES and OIL are other ETFs that provide exposure to oil.

Technical Analysis Challenge
When prices are at all time highs and way above previous resistance levels, it is difficult identify a top in the market. We have hence drawn Fibonacci price extension lines to get some sense of the upside potential. We however feel that the future oil cannot be gleaned from the charts for now. Once the price of oil falls, we will have plenty of support and resistance levels that we can target. For now we have to look at other factors that can influence the price of oil.

Click here for chart of USO
Click here for chart of DBO

Reading the Charts:
The white horizontal lines are support and resistance lines based on Fibonacci price extensions. Lines above the current price are resistance areas and below are support areas. Prices usually stop rising or fall at resistance and stop falling or rise at support. Support turns to resistance and vice versa once the lines area sustainably breached.

Our Take on Oil
We believe that oil is due for a correction as most of the conditions mentioned for the oil price rise may not be in play soon.

Speculation: Lots of governments have been talking tough about curbing speculation. Government intervention is bad for the markets, but it will bring down the price of oil

Supply and Demand: According to the Energy Information Administration (EIA), a unit of the U.S. Department of Energy, gasoline demand has fallen 0.6% so far in 2008. Additionally, China and India the two countries that increased marginal demand have hiked oil prices and reduced subsidies. This is expected to curb demand putting a downward pressure on prices. The willingness of oil producing companies to increase production will be another damper on prices.

Dollar Value: Since oil transactions are denominated in dollars a weak dollar pushes up the price of oil. The Federal Reserve has been cutting interest rates to prevent a crisis in the financial sector. This has caused a weakening of the dollar and a rise in oil prices. Given the rising inflation the Federal Reserve is expected to hike interest rates, which will strengthen the dollar and put a downward pressure on oil

Supply disruptions: Keep an eye on supply disruptions from unstable oil producing regions. This can lead to a rally on oil.

Conclusion
There are a number of factors at play to bring down the price of oil and we recommend not going long on oil. Take some profit now, but do not short oil. We can begin shorting oil after the market has established strong resistance. However, if the Fed continues with its easy money policy or if there are supply disruptions, oil prices will continue rising.