Energy Sector Thoughts for the Next Couple Weeks
May 27, 2019 Trading Blog
Last week was an ugly one for the bulls as the XOP finally broke out of the three week range and hit a low of $26.72. That low took out the early February and early March low points. It seems that the E&P’s are headed for the December lows around 24.
The scary part for the energy sector is that the overall market may also just be starting to top out and roll over. The SPY was shaky last week as well, but it did hang in there and could test the highs around 295 one more time before coming down hard. If the overall market corrects, the energy sector is probably going to get crushed. The 24 area held on the last SPY correction, but that correction was based on a tantrum in response to the FED getting tighter and wanting higher rates. This coming correction isn’t based on that, in fact the assumption now is that rate cuts are a given. The correction now is more likely based on a slowing economy (requiring the lowered rates). If this correction is indeed caused by a slowing economy, that is a direct hit for oil. The supply/demand curve is already weak and if the demand side collapses then oil prices are probably looking at something under $50, possibly low $40’s. The FED might be able to save many sectors with lower rates, but energy isn’t one of them. Lower rates don’t stimulate growth or oil usage, they simply cushion the fall.
I’m not sure if anyone really knows the true picture for oil right now. For every report that says there is a shortage, there’s another that says there is a glut. Somebody is wrong. Many reports say there is a shortage of needed refinery inputs, but those grades aren’t increasing in price and gasoline isn’t increasing in price either. Something is wrong with the supply/demand evaluation and one side of the market is definitely getting it wrong. At this point, the news reports are meaningless and price is the only variable that counts. Right now price says supply glut and/or falling demand.
Sometimes looking to other commodity sectors helps produce a clearer picture of economic growth. The closest sector to energy is probably basic materials: aluminum, steel, copper, chemicals, lumber, manufacturing inputs. If you take a look at companies like X, AA, CENX, FCX, DWDP, DOW, MMM they are getting crushed just as bad as energy. These usually get a lift when rates are lowered, unless that reason for rate lowering is a steeply slowing economy. When the demand for raw materials starts to fall this quickly, it’s a pretty safe bet that the demand for finished products will be slowing in the future. Keep an eye on these to see if they give any hint to an upturn in energy.
Another clue is the DXY. Keep an eye on the dollar. It has been very strong, which isn’t a great help to oil. As rates start to get lowered, see if that brings the dollar down at all. The US is still way ahead of the rest of the world in rates, which in turn causes a stronger dollar. If rates start coming down closer to the level of other countries, the dollar may come down as well. That could help, but there is still the underlying problem of slowing economic growth.
So if we assume that the economy is slowing, dollar is strong and rates are falling, what is the best way to trade the E&P’s? The obvious answer is to short them, but that is the short term answer. I think the sector could test the December lows, but that’s only about three points away which isn’t really enough reward to justify the risk on that short trade. One or two news headlines and you could get caught in a big short squeeze. I’m not looking to short right now. I think the better play is to sit it out for a week or two, let these E&P’s show their hand at 24 and then BUY.
Energy is probably the most hated sector in the world right now. Everyone is on the same side of the boat on these things, and so far they have been right, but at some point the sentiment will shift and the opportunity is going to be huge. I think there is going to be a spike in oil prices soon and not just a small spike, but a realization that oil isn’t going anywhere and the last five years of low investment is going to lead to a big shortage that will last for a couple years. If you have been on Twitter, the CrudeQualityMatters argument has been around for about a year, but I really don’t think it has been given enough attention. Shale isn’t the answer to the supply/demand curve. It has limited uses. The US still doesn’t control the type of oil it needs for refinery inputs and that could be a problem.
But back to the short term trading picture, I am letting these things fall and test the lows around 24. If they never get there, then energy will have been stronger than I thought and it will be fairly easy to get long somewhere as they bounce. But if they do get there, there is a good chance they overshoot to the downside and that could be one of those opportunities that only comes around every couple of years in energy. Bull markets only begin when the last seller has thrown in the towel. If the XOP takes out 24 and heads toward 20, all of these companies will get dumped completely on a huge volume spike and that is the market turning point. You just have to be patient enough to wait for it, DON’T BE EARLY!
If the liquidation does happen, where do you want to be? I think you have to stay with quality. I might be more tempted to go with the XLE over the XOP. Some of the smaller E&P’s won’t make it and that might limit the upside in the XOP. Remember that in the XOP, something like QEP counts more than XOM because it is an equally weighted index. It’s the same argument for selecting the OIH over the XES.
If I had to create the perfect portfolio at the bottom, I’d go with XOM, CVX, MPC, SLB, COP, OXY, EOG, DVN, PE and COG. Equal weight them 1/10th of the portfolio and let them run for six months to a year. If you wanted to take on a little more risk, then dip down into the next tier with HAL, NOV, VLO, PXD, CXO, CLR, HES, NBL, APA, MTDR and RRC. The argument could definitely be made that PE could be replaced by PXD/CXO in the perfect portfolio, but I think PE could really be a huge winner in the Permian. If PXD/CXO run up, PE will likely run up more. One subsector that also might be a winner in the next year is offshore. When it becomes clear that shale isn’t the answer and that it has reached it’s maximum usage level, the larger companies will move back to longer term projects for a different quality of oil. RIG, ESV, DO, OII, FTI. These would require a little bit longer timeframe to hold. These are just my opinions, not advice!
The question is how far down do you want to reach if this sector collapses? At what level do the bankruptcies start to happen? That’s definitely a tough one. I think you stay away from any services companies other than SLB, HAL, NOV, HP, CLB, BHGE. I think most of the bankruptcies are going to hit service companies, not E&P’s. When looking at E&P’s, it all comes down to debt, those are the spots where you don’t want to gamble. That’s really all I think you can do. Many of these smaller stocks are risky gambles now and if you really want to be in energy, stick with quality and don’t get greedy trying to hit a home run with these small and micro cap stocks. The returns in the quality names will be large, no need to take the extra risk of getting pinched holding a bankruptcy victim.
So that’s the plan, sit it out for the next couple weeks and let this sector fall to the 24 level. See if it overshoots and has a volume climax and then start scaling in slowly. If it never gets to 24, then I’ll move back to scalping the long side. The goal for me is to get positioned on a spike down for a longer term hold and large return. These opportunities don’t come around very often and you at least have to give them a try.