Oil and Gas Equities Weekly Outlook for Monday, April 23
Apr 22, 2018 Trading Blog
It was a very strong week for the XOP and energy stocks in general. I was mostly on the sidelines until Friday, but I’m starting to get back in the flow with the bullish side of the market. To be honest, the spike in oil prices really caught me offsides and I didn’t appreciate the underlying factors enough. I saw them, I just didn’t think they would spike the price that quickly. I’m still not fully bullish short term and my longer term view for energy stocks is still bearish, but as Livermore says, “The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation.”
So now where do we go? The supply side issues are becoming more obvious. The SLB earnings call made a clear fact that the lack of Capex spending is catching up with the market. The low prices over the last couple years have caused companies to cut projects and now that lack of production is starting to show. There are also the natural declines in Venezuela and a few other places and a new pipeline attack in Libya. Decreased supply equals higher prices, simple supply and demand. This issue is also one that won’t be fixed quickly, even in the shale environment. That fact alone probably would have eventually brought prices back up, but at the same time OPEC has added to the supply reduction with their voluntary supply cuts and I think this is what finally caused the quick spike in prices. A reduction caused by lack of new projects combined with the voluntary outputs finally reached a tipping point, likely exacerbated by the recent geopolitical events. Put all those together and of course we get the resulting price spike. I just wish I would have put the pieces together a week or two earlier.
The current environment now has this lack of production caused by low spending and it has an OPEC stance that doesn’t look like they want to eliminate their voluntary supply reductions anytime soon. OPEC had to have known this would happen, and they probably wanted this spike. They were well aware of the worldwide reductions in supply and they chose to cut (and continue to cut) anyway. The resulting oil price will now depend on whether they decide to eliminate their caps. If they don’t, oil prices could keep spiking toward $80.
So far, it seems the market likes this rising oil price as the XOP has ripped straight to the January highs around $40. But, while I do see the short term bullish trading case, I also realize that there could be a very sharp end to this rise if a couple things happen. First, at some point rising oil prices will hinder economic growth. I think this is probably the underlying reason for the recent Trump Tweet on oil. If oil prices become a concern, actions could be taken to bring them down and you just never know what kind of wildcard actions Trump could explore. Oil prices are always a convenient excuse for a slowing economy and I wouldn’t doubt that Trump would lean on that to cover any growth stagnation. Second, rising prices eventually crush demand. Demand has been incredibly strong over the last several months, but will demand continue at these high prices? The real problem here is that demand is a hard thing to reverse once it tops out and starts down. Be awake to the weekly demand numbers as those will probably start to be more closely watched to see at what level rising prices start to hurt.
Third, rising commodity prices, specifically energy, will eventually have to be dealt with in the form of rising interest rates. Rising rates haven’t been an issue over the last couple of months, but this past week the TLT had a breakdown and that may be the first shot fired on energy inflation and rising rates. Keep an eye out for any mention of rising inflation and resulting effect on interest rates. If energy prices keep climbing and cause rising rates, stocks might be in trouble, including energy stocks. Once that high water mark is put in for energy prices, so too might the high water mark for energy stocks. I think right now we are in a situation where nobody really knows where the top is and that causes a great deal of emotion and panic buying, especially for anyone still short. Once there is some certainty on the price range for oil, then I think energy stocks will move back to a more stable trading environment.
Another concern is the continuing geopolitical issue surrounding the sanctions on Iran, which I think the deadline on that comes up around May 12. That issue has the ability to shake up oil even more. The Syria issue seems to be calming a bit, but could always spark back up at any time.
There is also the lingering Aramco IPO and the desire for oil prices to be high for a rich valuation of that company. While this might be a great side benefit to SA, I don’t think this IPO is the cause of spiking oil prices. I’ve read conspiracy type pieces saying that this whole spike is just a ploy for that IPO, but I don’t really buy that.
One other thing that I wrote about last week was the ability of US companies to increase their budgets for increased production. Keep an eye out to see if any company actually does this. These higher prices will test to see if they are truly committed to shifting from production increases to shareholder value. Will the high prices lure US companies to increase production? If US companies do increase production, how does that affect oil price? How would an increase in US production COMBINED with slowing demand affect future oil price? It feels like OPEC is baiting companies to increase their investment and spending, even directly using that as one of their directives for the cuts. You always have to ask yourself, how easy would it be for OPEC to lure companies to overextend themselves and then yank the rug right out from under them with the elimination of their supply cuts. New outspending cash flow combined with an oil price spike downward would be a disaster for US companies.
One thing about oil (and gold) is that the spike up can be great for stocks, but that spike down can be a killer. Sometimes the higher the climb, the deeper the fall. Can energy stocks survive another oil collapse in the next 12 months? How much will they spend on hedging at these high prices? I’ve still got a little bearish bias on my longer term view. I think oil will hit a wall at some point, either caused by OPEC reversing their stance on supply cuts OR by demand finally slowing. If either of those ideas take hold, oil could fall quickly and take energy stocks right back down with it. For now though, I think you have to stay on the long side and do it in a nimble way. The opportunity for longer term trades is not attractive to me at all up here near XOP 40. I’m only interested in short duration trades on the long side up here, just trading opportunities not swing trades. If the market can pull back to the 37 range, then I would definitely be interested in some longer term swing long trades. The emotion in this oil market can make it very difficult to trade, however it can provide some occasional great opportunities. You just have to be patient and wait for them, and if you miss a few then don’t worry too much about it, there will always be another coming soon.
As a bit of a side note outside energy, keep an eye on how the electric vehicle hype grows as oil prices rise. There could be some trading opportunities in some of the electric vehicle manufacturers, battery producers and battery commodity miners. There might also be an opportunity in some of the solar stocks. On the flip side, keep an eye on the transports, specifically airlines for possible shorting opportunities. Most are hedged really well, but if oil prices cut into their profits and we also see a slowing economy, air travel might suffer.
For this week, watch for news regarding the demand side of the equation for oil. At what level does the economy start feeling pain? Also, watch TLT for clues on what rates might be saying about rising energy prices and their effect on inflation and possible rate increases. Watch for any communication out of OPEC regarding their stance on extending cuts into the future. Earnings season kicked off Friday for energy stocks, so also watch for any clues regarding increased spending in any of the upcoming reports. And as always, keep an eye on the SPY. It looked pretty steady last week, but I’m still cautious on the overall market.