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Weekly Energy Equities Review, Market Outlook and Trading Plan for February 8-12

I’ve got a confession to make, I’ve been slacking on keeping up with my EIA stats. I looked at my notes and my last entry was October 16, 2020. Yeah, it happens. So I figured since USO has run up about 55% since November 2nd, that I should probably go back and fill in the information in my EIA journal to see exactly why the incredible price run in oil happened. I expected to find big drawdowns in oil, gasoline and distillates, import/export changes, higher refinery inputs and all the other stuff that would have alerted me that a big jump in oil prices was coming. But you know what I found? Absolutely NOTHING. Much like the rest of the market, oil prices have disconnected from the normal fundamentals.


My last EIA entry on October 16 recorded oil inventory at 488, gasoline at 227 and distillates at 161. Compare that to the last EIA report of January 29: oil 476 (only because of a 9.9 mil draw Jan 15), gasoline at 252 and distillates at 163. Oil was roughly the same without that one Jan draw, gasoline was HIGHER and distillates was HIGHER. Yet WTI ran from $34 to $57. What’s going on here? The only significant stat in the entire journal was an increase in refinery inputs from 13 million on October 16 to 14.7 million in the latest report. That’s about a 10% increase in oil to refineries, yet oil inventories are staying much the same with those refineries producing HIGHER and GROWING inventories of gasoline and distillates. Overall production numbers since October have remained constant at around 11 million. So why the 55% increase in oil prices?


One of my favorite places to look for clues is the refining sector. I watch the big three of MPC, VLO and PSX. Since late October, MPC has run from 27 to 48, VLO from 36 to 63, and PSX from 43 to 76. Refineries are a simple concept. Oil is pumped in, turned into product which is then sold. The goal is to sell the produced product for more than what the input oil costs. Since October the input cost has risen from $34 to $57, about +55%. The prices for the produced products haven’t increased much at all and products supplied (measure of demand) have remained fairly constant. Yet the stock prices as a percentage have risen even MORE than the percentage increase in their input costs (oil). More questions. What’s going on here? More disconnect?


Yeah, I know, the first response I always get is, “the market always looks ahead”. Maybe. What exactly would have to happen in the economy to justify this 55% increase in oil prices? Perfection? Is the market really looking ahead here and basing this huge run in oil on expectations that things are going to get that much better? Or is there something else? I don’t get into earnings reports that deeply,  but I took a look at the latest from RDSA the other day and I was pretty surprised. They aren’t looking for perfection in the future at all. In fact, their report was a complete disaster without much hope. It’s pretty much the same story for the other majors. More disconnect. The only positive I can find for any of these guys is the golden dividends. If that’s what people are betting on, then we are in real trouble and these things are way overpriced. Also, with regard to the dividends, if rates do keep rising, these dividends look less and less attractive, so there’s that possible downside for the big oil dividend payors.


So I guess the real question remains, why are these stocks, and oil,  rising so fast on what looks like a fairly blah current and future picture? Why the disconnect from the fundamentals? I think when we look back a year from now it’s going to be crystal clear that we are currently in a huge bubble that nobody can see. It’s like the 300 pound guy eating a donut and saying ‘these things are going to make me fat’. No dude, you are already fat and it was the dozens and dozens of donuts over the last few years that got you there. It just happened so slowly that you couldn’t see it. This bubble is like the frog boiled alive. The problem right now for traders is that they can’t see the forest for the trees. We are smack in the middle of the EVERYTHING bubble, yet nobody wants to acknowledge the obvious. Or maybe it’s just too obvious to acknowledge? Everything is in a disconnect right now, yet hope reigns supreme and everyone is in denial. This is one of the most difficult situations to trade and it takes incredible trust in your own skills and point of view to separate yourself from the herd. There’s absolutely no doubt, this is a bubble. The question is, how far do you think it’s going to go and can you time it well enough to profit from it?


Getting back to energy, I took a couple shots on the short side this week, but scratched them breakeven. I’m bearish. I feel like I’m the only bear left standing. But I truly believe that I’m right and this entire situation is a bubble. I traded through the internet bubble back in 1999-2000 and this market has many of the same qualities. The one similarity in both bubbles is that focus has shifted away from the present conditions (earnings and fundamentals) to instead focus on the utopia of the future. Attention has completely shifted from the problems of the current to how great the future is going to be. It’s a total belief by everyone that the future is going to be perfect. In 2000 everyone completely ignored the fact that most companies were making no money, but instead everyone focused on ‘how great the future of the internet was going to be’. Until it wasn’t. The same thing is staring us right in the face now. Everyone is ignoring the current problems and instead telling themselves how absolutely awesome the future will be when all this virus stuff goes away. Until it doesn’t or there’s other problems (like war, recession or any other black swan) to replace the virus.


The real problem right now in energy, as well as in small caps, electric vehicles and other green tech, is that the view of the future has replaced the reality of the present. The herd believes things MUST get better, but are you willing to bet your money that it will? I used to do a lot of sports betting in my younger days and there’s a method of betting called totals, or over/under as many refer to it. The market right now is very similar. The novices always bet on the over. They want scoring. They want things to happen. They want perfection and excitement. They want players to succeed and put up points so their over bet succeeds. They are optimists. The pros on the other hand never fall for it. They accept reality and bet the under. Novices wish for things to happen, pros accept that change probably won’t happen and that utopia isn’t a likely outcome, especially at an elevated price risk. And the pros are usually way more successful in their bets than the novices are. Are you betting that things are going to be perfect in the future, and paying premium odds for that bet? Or are you a pro and realistically accepting that things are what they are and taking the better odds under bet?


I know I got a little off topic there, but my point is to really make new traders question WHY this incredible run is happening, as well as making them question whether paying a premium to bet on perfection is really worth it. It’s no secret that I’m bearish for the next few weeks, so keep that in mind as I go through the macro picture below.


SPY – In last week’s run through the macro picture, it was clear that if the SPY based on that VWAP from late October it was going to take a shot at the highs. And it did. It was the same story for the QQQ and IWM. Last week’s run in the SPY felt a little different though. It was a straight up grind, which is very indicative of everyone being on the same side of the trade. Most Wall Street targets FOR THE YEAR are clustered around 400 and a melt up here could hit those targets. I keep seeing people predicting a big blowoff top is coming. But the real question to me is has it already happened? Was the run from November the meltup that everyone is predicting and they just don’t realize it? Are we all just frogs sitting in boiling water? The point to watch this week in the SPY is of course the high around 388.50, but more importantly watch the 381-382 area to see if there is enough demand there to support this latest rally. If 381 breaks, I wouldn’t be surprised to see the SPY give up all of last week’s gains, and more.


QQQ – Tech also made a new high, but there are warning signs and divergences everywhere in this sector. The biggest red flag to me is the divergence between the QQQ and SMH. Watch the 235-236 area in SMH on Monday. If it can break above that, then there’s another big supply area in the 238-240 area. If price fails again there, that could be a clue that tech is running out of steam. As for the rest of the FAANGs, AAPL and FB show similar divergences and AMZN can’t really decide what it wants to do. If the SPY does pull back this week, see if money runs to this “safe haven” of mega cap tech. Also, the inverse correlation between QQQ and IWM remains in play.


IWM – When this market finally acknowledges the ridiculous blowoff, this is the area that I’m targeting for a short. This thing is the biggest bubble in the entire market. There’s so much hope and euphoria that the small domestic businesses in the US are going to come out of this virus situation bigger and better than before, but I don’t buy it. I saw a graphic last week that the top 25% of the IWM businesses were trading at 100x earnings. That’s crazy expensive. These same small domestic businesses are also the most sensitive to interest rates, which are starting to move up. At some point, the market is going to get concerned about rising rates and the IWM could be the first domino that falls because of that fear. I’ve been doing my best to stay away from the sell button on IWM, but this might be the week that I put on a very big short play. I’d love to see a huge gap up Monday or at least a big run up Monday/Tuesday to start a short position Wednesday. Watch the 214-215 area to see if demand supports last week’s rally. Much like QQQ, if that point fails, IWM could give up all of last week’s run.


TLT – This is probably the most important watch for the upcoming week. As bonds sell off, that money flows to equities. The decline in TLT (rising rates) is getting mature and very stretched and might be near a reversal point. When it does reverse, I think financials and energy probably roll over. As of Friday’s close, financials (21%) and healthcare (20%) made up 41% of the IWM. If rates start to fall and financials drop, that’s going to hit the IWM hard and could be the catalyst for a reversal. If the TLT continues to drop this week, I’ll be more conservative on my short plays. I have no desire to fight this bonds/equities correlation.


GLD – Gold was interesting this week. GLD and TLT have been moving together since August, however they diverged sharply toward the end of last week. TLT had a severe move down, yet GLD managed a decent rally Thursday and Friday. See if that relationship gets back in sync this week. I think there’s a great trade setting up in GDX if it can drop down to the 31 area. It got near 33 last week and looked like it might collapse, but buyers stepped in. I’ll be getting long on any move down to 31.


UUP – I don’t think many traders appreciate the move that has occurred in the dollar over the last few weeks. It has turned upward and could be headed back up to that August-November range. If you compare the IWM and UUP charts you will see that the big run in IWM started at the same time as UUP broke down out of that Aug-Nov range. If the UUP can climb back into that range, that’s a clear warning that the IWM is overextended and due for a pullback. The UUP/GLD inverse correlation is functioning properly and if the dollar continues to strengthen, it could push GDX to the 31 level described above. Also, keep an eye on the TLT/UUP correlation this week. As rates rise, the dollar becomes more attractive for yield. If you compare the two charts, the turn upward in the dollar around January 1 corresponded exactly with the breakdown in the TLT. See if those two continue their inverse correlation, as it has great influence on banks, miners and E&P’s.


XLF/KRE – The direct correlation between banks and energy continues to be in effect. Banks (and energy) have also been the beneficiary of the rotation trade out of tech. As the TLT drops, rates rise and banks make more money. Watch rates this week to see if they keep supporting banks, specifically the KRE. If the KRE starts to weaken, then I’d expect the IWM and XOP to move similarly. Any divergence in the KRE/XOP/IWM correlation would be important.


Energy XLE/XOP – I’m concerned about energy right now. It feels like the run off the bottom is running out of steam, as the equities are diverging a bit from the actual commodity. As I described in the open to this week’s writeup, the fundamentals just don’t support the latest run in oil. Something else is causing the move up. I’m just not sure what that something else might be. One thing that is starting to concern me though is geopolitical tension, mostly Iran. That situation has the potential to get out of hand quickly if Biden isn’t careful. Other than that, I think it’s a simple reflation speculation trade, as well as the overall bubble frenzy, that is taking oil well past what the fundamentals would support.


If you go back to the March OPEC disaster, the XLE was trading around 46, about 10% higher than where it closed Friday. Looking at oil itself (WTI), it was trading around 47 during that OPEC meeting. It closed near 57 on Friday, or about 20% higher than where it was during the OPEC disaster. So we have the XLE closing 10% lower than where it was in March while oil trades 20% higher than where it was in March. One of these two things is very wrong. Are the equities too low or is WTI too high?


Given oil at 57, the equities should be trading higher, yet they aren’t. And this is with the market making new all time highs on a daily basis. Logic would say that given the spikes in oil and the overall market, that the energy sector should at least be higher than it was in March. Further, almost every other sector is above the February pandemic start, yet the energy sector isn’t anywhere close to the 54 level where it was when the pandemic started. It would take a 30% move up just to make it back to that pre-pandemic level. Something is wrong with this sector, it’s still sick. I think there are many reasons why it’s lagging, and will probably continue to lag. Just take a look at the latest earnings reports from the majors, especially that RDSA report. The future is bleak.


While the bounce off the bottom has been nice and many people have managed to scratch their way back to breakeven from that March disaster, I think many are falling into some faulty logic assuming that this sector should automatically be trading higher simply because oil and the overall market are trading higher. There is a negative divergence going on and you can’t just ignore it. Yes, maybe I’m wrong and there’s a huge move coming in energy to play catchup with the rest of the market. But honestly, given the very small size of the energy sector and all the money chasing things lately, if this move was going to happen it should have done so by now. I think WTI and the SPY are now extremely stretched while the XLE still lags. What happens when WTI and the SPY top out? If the overall market does have a 20% correction, I think the XLE could find itself right back at that 30 level very quickly.


So how do you play it? For me, I’m looking for the short play. I’m looking for WTI and IWM to top out and roll over.  That’s the entry signal for the short XLE/XOP trade. This isn’t really a prediction trade, it’s more of a math trade. Could the XLE rip straight up and catch up with the rest of the market? Sure. However, it doesn’t take much risk to find out if that’s going to happen. If I’m right on the short play, then I can probably find out whether I’m right with around $2 risk. And the reward could be $6-8, maybe more. On the other hand, playing the long side is difficult. At this level, it would take a stop of 38 to find out if I’m wrong on the long trade, which is about a $4 risk. There’s just not enough reward in the upside to justify that risk. I’m looking at maybe $6 reward on the long side. The long side is offering me 1.5 R while the short side offers 4 R. And this is with the odds probably 50/50 on which direction we go from here. Short is clearly the better trade.


If I’m wrong on the short idea and the XLE does break that 44 level, I can always flip sides and use that 44 breakout point as an entry/stop for a long trade for a possible run at 47-48. There are many different ways to trade the XLE right now, but given all the weaknesses in energy I’ve set out above, combined with the odds and payouts on the short idea, I think the clear choice for XLE is a short play.


As for the technicals in energy this week, the point to watch in XLE is 41. If this rally is to continue, there has to be demand at last week’s VWAP. If 41 holds, then the XLE probably takes a shot at the high around 43. If 41 fails, there’s a good chance that the XLE gives up all of last week’s gains and the pullback is on. On the other hand, if we open Monday and immediately take out 43, then the next confrontation with the bears comes in the 44-45 area, which tests the June and January high marks. A third failure there would not be good.


The same basic outlook applies to the XOP. However, the XOP has been a little stronger, mostly because the smaller cap holdings have been a favorite of the speculators. Weaker companies like CPE, CDEV and SM have similar weightings to XOM and CVX in the more equal weighted XOP, therefore those large moves in the small caps have overshadowed the larger caps and have led to a bigger move in XOP than in XLE.  That same logic will also apply when things turn downward. The point to watch in XOP is 68. If the rally is to continue, demand needs to show up at last week’s VWAP. On the upside, watch the 72 level for a possible breakout and test of the March OPEC price of 76. That would be my ideal spot to get short as there should still be a lot of traders holding from that point would would love to dump their holdings at breakeven. In addition, there’s a fairly large range extending from August 2019 to February 2020 which should also contain a lot of supply which should put a cap on the upside.


Sorry that kind of got long this week. The plan for the week is basically a short play in IWM with a scale in likely starting on Wednesday and a short in XLE and/or XOP when the IWM and WTI look like they are topping out. This market is getting dangerous, so tighten up the risk control and money management. Good luck this week.

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