Is Energy a Falling Knife Worth Trying To Catch?
In the crazy equity markets that we are forced to work with, there is one notable equity sector that has not held onto Trump rally gains. Energy is by far the worst performing GICS level 1 sector in the U.S. this year. The S&P 500 Energy Sector is now down -10.3% year-to-date. The Exploration & Production companies (XOP) are even flirting with a bear market. At the same time, overvalued technology, staples, consumer discretionary, and industrial sector companies are finding a strong bid before prices come off even -2%. While in this buying frenzy, the short-term trade is to crowd into Apple, Google, Amazon, Facebook, and Microsoft, investors with a longer-term horizon need to step back and consider allocating to stocks that have not been trading at all-time record highs for several weeks or months. This week we review the energy sector.
Since bottoming in February 2016, West Texas crude oil prices have been dancing between $40 and $55/ barrel for almost a year. Oil price have come off twice this year after trading above $53/barrel. We chalk up the two sharp sell-offs in crude oil between March and May to technical trading and sentiment, not due to poor underlying fundamentals. As seen in our Sector Allocation model, the energy sector indexes have been bleeding red for some time.
The recent inventory build has notably soured short-term trading sentiment. Indeed, weak oil prices in March and April were mainly driven by surging inventories. The Department of Energy reported that the change in crude oil inventories rose each week throughout the entire first quarter, including one of the largest crude oil inventory increases in U.S. history in February. The increases in U.S. oil inventories are not a surprise as the first quarter is a seasonal period when inventories typically rise. Looking at the 4-week moving average in inventories, we see that inventories have in fact been falling for several weeks now (blue line, inverted scale in the chart below), with a big -5,247,000 barrel drop in the week ending May 5.
While the first quarter typically sees inventories build, the summer months are a seasonal period when U.S. oil inventories decline most weeks. We can expect to see a consistent reduction in U.S. crude oil inventories very soon. To this point the recent trend lower in U.S. crude inventories is encouraging. In five of the last six weeks, the change in U.S. oil inventories was at or below the low end of the five-year range. If this trend continues, there will be some substantial declines in U.S. inventories in the weeks to come. As traders get more evidence that the oil inventories decline will be sustained, we expect the West Texas price to begin perking up.
As we head into the famous “summer driving season”, when Americans take to the roads, we looked at the seasonality of oil prices. Our chart below shows that West Texas oil prices tend to be quite stable over the next three months. Spring (March and April) and late summer (August and September) tend to see the strongest advances in oil prices.
More importantly, the prices of oil exploration and production companies (XOP) track fairly well the seasonality of crude oil.
While the seasonality for crude oil over the next three months is rather neutral (returning favourable in August), thus far this year seasonal trends have been thrown on their head. March and April, traditionally the strongest two months of the year, saw West Texas crude oil return -6.3% and -2.5%, respectively in 2017. Perhaps strong seasonal gains from March and April will be pushed forward into the summer months this year. Given the potential tailwinds for oil, we don’t see seasonality to be a headwind for oil prices this year.
The next big event on the energy sector calendar is the upcoming OPEC meeting. OPEC’s production cut agreement is likely to be extended at the bi-annual OPEC meeting on May 25th. All signals coming from the major players such as Russia and Saudi Arabia point to an extension of the agreement. While the production cut agreement would be likely be extended through the end of the year, some recent news organizations have reported that an extension of the cuts into 2018 is being discussed. This would be great news for oil prices. Regardless, the OPEC meeting should remove significant uncertainty from the current global oil markets.
Buy High or Buy Low?
As we look at where energy is trading relative to “hot” sectors or companies, we marvel at the divergences that have formed. It has always been the nature of markets to overshoot reasonable valuations, as investors euphorically crowd into hot sectors/companies while neglecting other sector/companies.
On one hand, we have oil exploration and production stocks not far off cycle lows.
On the other hand, U.S. technology stocks are trading at cycle highs
In Europe, while most broad equity benchmarks are a cycle or record highs, the Stoxx Energy Index is also a laggard.
The former largest stock by market capitalization, Exxon Mobil, has returned to U.S. election lows….
…while the current largest stock by market capitalization, Apple, is not looking attractive for investors with vertigo.
While fundamentals in the tech sector remain favourable, prices have likely gotten (very) ahead of themselves. One feature of this bull market is the rotation into lagging sectors, which has allowed the broad market S&P 500 to avoid any type of serious correction since 2011 (note that several individual sector indexes saw near bear markets of -20% over 2014-2016). To this end, it was the lagging banking sector that drove the initial Trump rally. Sure, the promise of deregulation was a bullish narrative for banks, but not to the point of re-valuing the business of Goldman Sachs, for example, 60% higher! Rather, the S&P 500 Bank Index was still trading -44% below 2007 highs. Investors simply chose to buy what was not already trading at record highs. The next rotation may well involve the energy sector, now trading well below 2014 highs.
Among the large cap energy names that are trading significantly below their highs and offer attractive fundamental scores we find:
ConocoPhillips, ticker COP (see S&P 100 Trading Model, page 2). ConocoPhillips is trading -41% below its 2014 highs, while earnings revisions remain strong, consensus analyst recommendations are positive, and the stock offers a nice yield.
Chevron, ticker CVX (see S&P 100 Trading Model, page 2). Chevron is trading about -10% below recent 2016 highs, while the stock offers an attractive price based on analysts’ future target prices (high potential), receives a favourable recommendation from the majority of analysts, and the stock offers an excellent yield.
Halliburton, ticker HAL (see S&P 100 Trading Model, page 4). Halliburton is trading about -22% below early 2017 highs, with very high revenue growth and strong upside potential based on analysts’ targets for the stock.
ENI, ticker ENI (on Milan) (see Stoxx 600 Trading Model Trading Model, page 3). ENI is trading about – 12% below 2014 highs, with an attractive valuation, decent earnings revisions and a superb yield.
These stocks on our buy list, awaiting positive relative price momentum scores in our models. While we prefer avoiding falling knives, buying too early in a downtrend, investors with a longer-term horizon, and a distaste for buying overvalued and crowded stocks, could consider feathering into energy sector positions already.
Conclusion
While U.S. shale fracking and a structural shift lower in the cost of production have suppressed oil prices recently, these headwinds may be offset by numerous positive factors for oil. Global oil demand has been revised higher, now forecast to increase by approximately 1.4 million barrels per day in 2017, as China economic growth looks ready to pick-up (Q1 GDP +6.9% y/y, the fastest pace of growth since Q2 2015). OPEC countries are finally collaborating again in cutting production in order to get oil prices higher. Finally geopolitical risks loom in oil sensitive regions. Any flare up in the Middle East, or with North Korea, should be positive for oil prices. Our belief is that oil prices will eventually settling in between $50 and $60 per barrel in 2017, which should support energy sector stock prices going forward. While short-term most energy stocks are still trending down, for asset allocators and investors with a longer-term horizon, the sector is becoming attractive. Keep energy stocks on your watch lists.
