Longer Term $XOP Thoughts, Past and Future
Nov 11, 2018 Trading Blog
I haven’t been writing too much about the Energy Sector lately, as I took June – September off. One factor that persuaded me to take the summer off was that I just didn’t agree with where the sector was going. I was completely bearish, yet the sector was trading bullish.
Did OPEC pull a fast one on US Shale??
In a posting on February 19, 2018 my bearishness peaked as the SPY stood at 273.11 and oil was trading about 62.50. At that time, most of the E&P’s were throttling back their CAPEX, increasing their dividends and increasing buybacks. They were not decreasing their debt. At the same time, the FED was well along in continuing their rate increases, which of course would make any debt more expensive in the future, and would also likely push the dollar up (eventually harming oil price). Presently, the FED is still on that path of rising rates, with another expected in December.
In short, I totally missed the price spike to the 75 area. Maybe not totally missed it, but I think I had convinced myself that even if it did spike, it was in no way sustainable and that prices would merely fall back to the $50 level. The XOP started a run on April 4 at 33.94 that lasted until May 22 where price peaked out at $44.75. That 6 week period made up the entire XOP run and if you missed that move, then you probably didn’t make much money from the E&P’s. From May 23 until October 19, the XOP stayed in that range of 40-45 trading sideways. Absolutely nothing there for the longer term trader. During those five months, my feeling was that these energy stocks were being distributed at that level. I didn’t feel comfortable taking long positions and I certainly didn’t want to short the market with the SPY ripping up and Oil spiking into the 70’s. So I sat it out.
In that February post, my main fear was that the energy sector was increasing its obligations in order to attract any buyers for the stocks that they could, as energy stocks were tanking fast. The gimmick of dividends and buybacks seemed to work given that 6 week XOP spike. Was this a manufactured move to distribute energy stocks? My concern was that the companies chose to increase dividends and buybacks, when they really didn’t have to. They put themselves on the hook for future obligations that might be very difficult to comply with if oil prices fell back down to the $50 area. Instead of having plenty of cash flow in the future, it could be possible that they would instead have to resort to more debt to meet the obligations. At the same time, they stopped increasing their CAPEX. If they thought oil prices were going to sustain in the $75 range, then why cut drilling and production?
Was I wrong OR was I just early? That oil price spike into the 70’s did produce a great deal of free cash flow to many E&P’s, but rather than paying down debt with it or choosing to increase their CAPEX or longer timeframe projects, they chose to increase their other (non-mandatory) obligations.
So now we get to the latest drop in the XOP. What is the cause? The ETF has gone from 44.81 on October 2 to a low of 34.02 on October 29. It fell almost exactly back to the point where it was when I wrote my post of February 19. Oil itself has fallen from about 76.50 to 60.00, which is even a bit lower than where it was on my February post. What happens to these companies if oil does indeed fall back to the lower $50’s? Do the dividends survive? Do the buybacks survive? Does cash flow survive? Were the recent good earnings just a one time off event? Are future earnings comps inevitably going to be worse compared to the most recent quarter? Do these dividend payers now have to resort to more debt (at now higher rates) to satisfy these obligations?
What happens if oil somehow drops below $50? The recent spike now seems to have been a temporary benefit for US Shale and they played it curiously with their choice to increase their obligations. Did OPEC pull a fast one on US Shale with those production cuts which resulted in a temporary price spike? Did they correctly predict that US Shale would overextend themselves with the expected price move upward, only to yank the rug now and crash price, thereby resulting in US Shale having increased obligations with lower oil price? I’m not sure that it was possible to do this, but if it was their plan, is it working?
Further, it seems that we are likely moving toward lower oil prices rather than higher prices over the next few quarters. Maybe it’s just normal cycle. Also, I still have concern about the demand side for oil. Eventually, this economy slows, especially with increasing interest rates, and that could spell trouble for oil. I think we get closer to a recession every day, rather than getting farther away from one. Everything I read states that production from all over is at peak levels. US Production hit 11.3 million, SA production is up, Russia is up. How long can price hold up with this record production?
As you can see, I’m still bearish on the E&P sector. Right now, it needs to find some kind of bottom. Looking at the XOP, that bottom could well be down near 32 if oil price falls back toward $50. If oil takes out $50, then who knows where the XOP could end up. There will be rips back to the upside on news, especially if OPEC talks up another cut. At least the XOP is moving again, making for some nice trading conditions.