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Weekly Energy Equities Review, Market Outlook and Trading Plan for February 16-19

Twitter is a great place for exchanging market opinions. You can find almost any opinion on there to support any trade or market view. But one thing I’ve noticed lately is not so much differing bull or bear opinions, but simply the fact that energy seems to be drawing a greater number of opinions, and the opinions are starting to be more assertive and emotional. Much the same thing happened in March during the OPEC fiasco. Last March you couldn’t find a single bull anywhere, now you can’t find a bear anywhere. Significant? Does this increase in hype and emotion mean we are reaching a turning point and a possible market pullback? Maybe.


One thing that is a bit strange on this latest energy run, and the entire market for that matter, is that nobody has really given any reason for it, yet I can give a list of reasons why it’s probably shouldn’t be running. The biggest and most common bull reasoning floating around Twitter is some form of, “the economy is going to be lit AF as soon as this virus is over bro, party on oil!”. It’s almost as if everyone is looking for this mystical promised land somewhere in the future, yet the view has absolutely no grounding in reality. That kind of situation was exactly like the internet bubble where all the problems of the present were simply pushed aside for the utopian future that the internet was going to bring.  Is oil running on its own merits or is it simply a broken down boat being lifted by the tide of the overall market and looking for some mystical shore?


I feel like I’m the only energy bear in the world right now. I haven’t found the right trade yet and I have no short position yet, but I think the opportunity is coming soon. This market is getting close to a blowoff, both overall and for energy specifically. I’m not sure exactly when it’s going to happen, but I’d guess within the next 6-8 weeks. Here’s a few reasons why I think this energy move is about to exhaust itself:


The first angle I think people are missing with oil is the political angle. Can Biden stand the pressure of $60+ oil? At what point do rising gas prices start to take a toll on a very weak and recovering economy? Many times high oil prices are itself the thing that kills the sector run. If this virus situation does magically go away, how far up are gasoline prices going to spike when travel opens up? These are the questions that the government and FED will have to deal with. Do we end up in a situation where the rise in oil prices is the cause of its own death? Biden does have some options for higher oil prices. Remember about a year ago when Trump filled the SPR with sub $30 oil? Think Biden won’t use higher oil prices as an excuse to release all that Trump oil at double the price and claim the profits as his own? Or does Biden use $60+ oil as an excuse to justify even larger regulation of fossil fuels and justify new green technologies which will hurt oil in the long run even more? There are many other political pitfalls out there and oil prices might be getting close to that danger zone where politics will become an issue for the bulls to worry about.


Next is OPEC. At some point soon, they will want to cash in on their work. They have done everything they can to get prices up and now it might be time to turn the taps back on and collect the benefits of that higher price. I think they have reached the end of their cuts and that might be a shock to the market at the next OPEC meeting. Russia is probably going to be the cause of those cuts ending or even reversing. Things aren’t going well for Putin right now and elevated gas prices aren’t going to help him. He agreed to cuts that he didn’t want a year ago, now he’s going to be expecting Saudi to return the favor by ending those cuts. I feel like the market assumes these cuts are going to last forever and that this is the new normal, well, it almost assuredly isn’t. Remember how the stock market responded to the FED’s taper? You could very well see the same response in oil to an OPEC taper.


OPEC also finds itself right back in the situation that started this price war. Prices are rising and US shale is putting rigs back to work and increasing production. You think Saudi is going to keep the cuts in place while the US jacks up production and takes advantage of the high prices that OPEC created? Not likely. There’s a good chance we have reached the end of this cooperation cycle. When things got tough everyone banded together to save oil prices, but now that price has recovered it’s back to normal competitive behavior. Can US shale compete?


SPR and OPEC issues are really just supply side elements. As I wrote last week, EIA numbers haven’t budged during this latest oil price run. Inventories sit right where they were back in October, with gasoline and distillates being even higher. That’s very similar to where things are all around the world on the supply side. There’s still a huge amount of supply out there and it’s just waiting to be tapped. I keep seeing all these claims of low supply, but the numbers just don’t confirm it. There’s also another side to this problem – DEMAND. Just as the weekly EIA numbers haven’t shown much change in inventories, they also haven’t shown much change in products supplied. Current demand just isn’t there yet.


If oil is going to justify this latest run, demand is going to have to pick up, and soon. The market seems to have this fantasy that oil demand is going to climb back above pre-pandemic levels, but I think people are very wrong on that prediction. The psychology of the public is damaged. It’s not a switch that can be flipped on and off, it’s going to take YEARS to change the attitudes of citizens. Just look at the mask issue. People can’t live without them now. You think when things get a little better that everyone is just going to take their mask off on the same day and throw them all in the trash? No. It’s going to be even worse with travel fears. That fear is real and it’s not going away anytime soon. Do you think corporations are all just going to bring every employee back to an office? No. Work from home is going to be huge from here on out. How in the world can you expect oil usage to get back above pre-pandemic levels when we don’t live in that kind of world anymore? Things have changed and oil demand will feel that change for years to come.


Also, the above assumes that the virus does go away. I’m of the camp that it’s here to stay for years. It can be managed, but it’s never going away. The government will continue to make more and more rules regarding travel. Instant tests, masks, quarantines, etc. Many people won’t travel just because of the hassle. Just look at what we do now, we are still taking our shoes off at the airport over ONE event that happened 20 years ago. The same will happen because of the virus.


We also have green technologies to deal with now. Look at all the electric vehicle companies coming online. You think that is going to help future oil and gasoline demand? Oil is a dying industry. It’s not going to be a sudden heart attack, more like a chronic disease that takes years to finally become fatal. But that death is coming. Most of us here are short term traders and we don’t move the market. If the energy sector is going to move to significantly higher levels, that’s going to require huge buyers with very long term outlooks.  Does the long term exist for oil anymore? Or has the oil sector turned into a “trading” sector where the money cycles in and out without any sustained gains or future? Look, I love the oil sector, but you have to be honest with yourself and realize oil is probably closer to its end than its beginning.


The above are just some of the things that I think will cause the sector to top out soon. If you notice, almost all the things listed above have nothing to do with the actual companies themselves. The energy sector is being pulled along by forces other than company fundamentals. If you really want a depressing look at energy, just take a look inside most of these companies. The huge debt is still there. The dividends are a massive albatross that is killing their budgets and cashflow. Management still contains the same idiots who were running the show a few years ago, taking huge bonuses and living with a drill until we die attitude. Many companies have used a majority of their prime acreage and are now down to second tier land. Take a look at the Baker Hughes rig count, it’s up big over the last six months, yet production hasn’t moved up, why? Maybe it’s just a delayed reaction, but what happens to oil price when all these rigs do start pushing production way above the current 11 million per day? Or are we down to second tier land that isn’t producing as much oil with the same number of rigs?


Sorry to throw all that negative stuff out there. I could probably throw another couple pages of negatives out there, but it all just points to the same conclusion. My point is to show that there are MANY negatives out there for oil, yet all I see everyone talking about is “how awesome everything is going to be when Covid goes away”. Traders are focusing on a dream of what MAY happen rather than focusing on the fundamentals and things that we know for sure. That’s how bubbles are, they lose touch with reality. It’s a recipe for disaster and that’s why I’m bearish right now. At some point soon, the true underlying facts will matter and the dream will die a quick death. That’s the point where I want to get short. If I miss some upside, that’s fine.


Enough with the depressing oil views. As for the rest of the market, I think there’s a couple more weeks of euphoria left in this run that started back in November. The Covid move started back on February 24, 2020 and we are approaching the one year anniversary. That might be as good of an excuse as any for a pullback.


SPY – The SPY was fairly flat for the week. It opened 389.30 and closed 392.64, and that’s with a $2 tape paint on the close Friday. Basically, the index did nothing last week. Momentum has stopped and some indecision has replaced it. The real question this week is whether this is just a pause to refresh and then a move up or if this is true indecision which could lead to a pullback. I think we will know by lunchtime Tuesday. If this thing gaps up and then takes out the 387-388 level, then it’s time for a pullback.


QQQ – Tech had a fairly flat week. It opened around 333 and was trading 335 before that final 30 minute pump on Friday. Same as with SPY, is this just a pause in the trend or is it indecision leading to a pullback? Watch 335 and 330 for clues.


IWM – Small caps are my short target right now. I’ve got about 40% of the position I want with an average price on the short of 227.75. I’d love to see one more blowoff move this week to get the rest of the money in. If I could get the average price on this trade up to the 232 area, I’d be very happy with the trade. One thing I noticed about the IWM this week was that when supply did hit, there were no buyers there. It’s almost as if traders are distributing this right now on the way up. The market only rises when there’s no volume. That’s a sign that someone wants to keep the price up to allow distribution at the highest price possible. I’d be much more bullish if the moves up were on good volume, but they aren’t. If a few big sellers do show up, I don’t think IWM has any chance of staying up against them. The only question is WHEN are they going to show up.


XLF/KRE – I think this sector holds the key to the overall market direction over the next couple weeks. I’ve posted the TLT/XLF correlation chart a few times and it’s holding true. As TLT moves down (rates up) the banks move up. It makes sense because the banks make more interest income with higher rates. I’m a little concerned about the relationship though. Last week bonds fell to new lows, yet the banks just couldn’t show any meaningful breakout. I can’t really count that final hour on Friday, which was a pretty suspicious tape paint on a boring Friday before a three day weekend. If banks fail again at last week’s highs, that’s the first red flag that the overall market might be getting ready to pull back.


GLD/GDX – I’ve been waiting on GDX to get down to the 31 level for a long trade, but I’m starting to think it’s never going to happen. It’s looking like GLD and GDX are both at a decision point right now. They have both been in a downtrend since last August and a change in that trend could happen soon. Also, there has been a direct correlation between GLD and TLT, so keep an eye on the TLT downtrend. If TLT starts up, I’d expect GLD and GDX to do the same. There could be a good trade there if you can time it right.


UUP/CAD – This might be the most important watch of the week, especially for energy. The UUP made an effort at turning upward and trying to break its long downtrend, but it has dipped over the last couple of weeks and now sits close to an important demand level around 24.30. I’m looking for the UUP to drop down and test this demand and if it holds, we could be getting close to a change in the larger dollar trend. The weak dollar is driving the entire macro picture right now, especially commodities, including oil. The USD/CAD is showing the same structure. There’s a level in the 1.2600-1.2650 area that needs to hold if the dollar has any chance at reversing. This relationship was very evident Friday. In pre-market trading, the USD/CAD made a big move up, USO was negative and XLE was down about 1%. But when the market opened the dollar collapsed, oil ripped up and took XLE with it. The correlations between these are getting stronger, so keep an eye on them. Also, if the UUP does make a big move up, watch GDX to possibly come down near 31 for an entry. It feels like everyone just assumes this dollar weakness is going to continue forever, but I think it may change sooner, and more sharply, than people are expecting, which is even greater reason for my cautiousness on energy at these elevated levels.


Energy XLE/XOP – I mentioned this in a Tweet yesterday, but if you go back to the early November run, the XLE went from about 27-28 first week of  November all the way up to about 42 on December 10. We now sit at 45. If you weren’t in for the month of November, you missed the move. The XLE has done almost nothing for the last two months. This is one of the reasons that I just don’t understand the “energy is a huge outperformer” crowd. Yeah, it had a good move for a month, as did the entire market, but what has it done since? ALL sectors are moving up and many have moved up even greater than energy since December 10.  Technically, it’s sitting in an uptrend channel, but right at the upper channel level. It’s also sitting at a huge supply level around 46 from the March 9 OPEC disaster, as well as the June highs of 47. The XLE needs to break that level soon or it’s going to get tired and need a pullback. I don’t know how much supply is in this 46-48 level, but the chart suggests that it’s a huge amount, but you never know for sure.


If the XLE does somehow break through this 46-48 level, there’s an even bigger supply level sitting around 54. That point basically marks the pandemic start level, as well as the lower range of an XLE specific range that started way back in 2018. Not a small level and there could be massive supply there that could be a cap on the sector for a long time. If I was planning a longer term XLE trade from the long side, the 54 level would be the highest potential reward number for the trade. That’s probably your max reward in the shorter term for risk management and position sizing calculations.


I also keep seeing people say that energy is setup for a short squeeze. I just don’t see it. Who would possibly still be short after that fall in March? Everyone who was short covered there for a very profitable trade. And the ones who didn’t cover on the March crash most definitely got squeezed out on the November run. There is no significant amount of shorts left in energy, that trade completed. There may, however, be a whole group of shorts on the sideline (including me) who are looking to get back into the short trade that was so successful over the last few years. Those sideline shorts are a part of the supply which resides at the 46-48 and 54 levels. Another huge portion of the supply at those two levels are desperate traders who have held throughout this entire Covid drop. I’d guess there’s a huge group who would be thankful to see this thing top 46-48 so they could dump and get out somewhere close to breakeven. So, you have new shorts looking to sell to enter, old longs looking to sell to get out breakeven, and a crowd of profit takers ready to sell and cash in their tickets that they bought in October-November. That’s a whole lot of sellers just overhead. Is the possibility of maybe making 6-8 points worth buying into all that possible supply and risking 7-9 points downside? I don’t think it is. The smart play is to wait for a pullback. I posted that chart on Twitter Saturday.


As I posted on Twitter, the XLE is just in a spot where the math says a long here around 45 just isn’t justified by the potential reward versus the potential risk. I’d say the odds of getting past the two overhead levels on a single push are very low, definitely lower than 50%. Here at 45 you are risking 7-9 points to make 6-8 points, that’s LESS than 1:1 or even money. At best, the trade is a long term breakeven play, at worst it’s a HUGE negative expectation play. The correct move right now (if you are bullish) is to let this pullback to 40 or so. An entry there gives you the same 50% chance of the trade winning, however you get paid 10-11 points while only risking 5-6 points. That’s almost 2:1, rather than the 1:1 you get on the 45 entry. You only need to be right about 33% of the time when you take a coinflip 50% trade getting 2:1 payout. That’s much better than taking the 45 entry which requires being right greater than 50% of the time to show a profit.


The point of posting the math above is that sometimes the fundamentals don’t matter. Opinion doesn’t matter. Being right or wrong doesn’t matter. Sometimes trading just comes down to the mathematical payout odds versus the probability. Like any good gambler, and we are ALL gamblers, making money requires that we ALWAYS keep the math and odds in our favor. I see too many people taking expensive trades. Yes, you may hit that inside straight draw and win the current pot, but over the long term you will bleed your money out until you go broke. Always think about long expectancy in trading.


Trading Plan for the Week – I’ve got the short IWM trade at 227.75 and I’ll be looking to add to that position. I’ll be watching for a gap open Monday that fails and re-enters last week’s range. At that point, I might add 10% to my short trade and then add if it gets near the bottom of last week’s range. If the IWM gaps up and starts running, then I’ll probably start watching the 231 area to start scaling in the other 60% on the trade.


The second watch is XLE. As I’ve been posting, I’m watching the 46-48 level to get short. The XLE is showing some relative weakness to the XOP, mostly because of the excessive movement of the very small caps in the XOP, so I’m more willing to be short the weaker of the two. If you prefer the XOP, then watch the 78-80 area for a possible short entry. If you are bullish, then XOP is the way to go for the play. If the XOP can break this pre-pandemic level, there is space to 96 if things get crazy. But remember, along with that bigger reward comes greater risk. If the IWM does collapse like I’m expecting, the small caps in the XOP will catch the worst of it and the XOP could come down faster than XLE. When choosing between the XLE and XOP, it’s simply a matter of how much volatility you are comfortable with. For me, I like the lower volatility of the XLE as it enables me to more effectively control risk. Also, keep in mind that weather is pushing the sector more than normal right now. This cold snap has been brutal for an extended amount of time. While this is great for the present, it isn’t something you can extend very far into the future.


Also, I apologize for not covering the individual energy names over the last few weeks. I’ll try to get back to that next week. When I’m bearish, I’m usually playing the overall sector with the ETF. I have no desire to short individual names, that’s how you get blown out of the water in energy.


Hope you guys all enjoy the rest of this three day weekend. Keep an eye on your risk control and money management next week, things could get crazy volatile very quickly in the next few weeks. Good luck and feel free to hit me with any questions.

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