Energy Market: Bearish and Overdone

Jan. 5.07 | About: Energy Select (XLE)

So what happens when a market dives about $5 in front of a bearish inventory report? Well, it bounces…a little….then dives more. At least that has been case thus far following the medley of oil numbers from the department of energy.

The DOE reported a bigger than expected draw in crude but higher than expected builds in the distillate and unleaded markets. Particularly negative is the fact that the unleaded inventory level is rising quickly heading into the month where traders generally switch their focus from heating oil to distillates for direction in this market. All and all, the lack of a bounce from the crude draw indicates that the market is now focusing on the fundamentals and they are not good!

The fundamental models that I use argue for continued weakness into next week. Last week I argued that if some draws were reported, we would see a bounce but instead, we received very large builds! Thus, the fundamentals remain weak. Continuing from last week, the global demand numbers continue to slow (which is opposite the last few years) and the rig count indicator remains in bearish territory. With today’s build in the distillate end of things and a slight tick up in residual, the current focus of the market is bearish. The substantial rise in gasoline is kind of interesting and makes me wonder if there was another mistake made by the DOE in their calculations? Or the crude market is in trouble.

Relative to the 10 year averages, Crude, gasoline, distillate and residual fuel are all within their 10 year bands. Gasoline skyrocketed past a year ago levels at this time and is approaching the top of its 10 year band. Distillates move in the same direction but not to the same extent. Residual actually trickled back into the 10 year bands and crude is even with the bands. Implied demand numbers are higher year over year for the distillate, gasoline and jet fuel but 22% lower for Residual fuel (according to bear Stearns). From a weekly perspective, implied demand numbers fell for distillates and rose a bit for gasoline.

Trading wise, this market is very beat up and probably short term oversold. My net index continues to argue for lower prices and is threatening to go negative for the first time since November. When the Net index last broke in August to negative, the price of crude moved from 73 down towards the 57.50 level. Does this imply that we see a sizable move again? Well, if you look at the weekly and monthly charts, there is a good deal of support in the current areas (long term says $56 while the weekly says $56.32) so stability may be coming. On the other side of this coin is the break in a trend line drawn along the lows of the rally since 2002 (almost back to 1999 actually). Normally when such a long term trend line is taken out, this is a major event and perhaps argues that crude will have a down year and more to come in then years ahead!

But I don’t believe it will be straight down. If you look back to the 1994/1997 time period, one could draw a trend line along the lows in 1994 and 1995. Once the trend line broke, the crude contract went sideways for about 7 months before falling. So if there is to be a break in crude, it may not occur till later this year. Thus, I would not be looking for a substantial break at this point and perhaps just a consolidation of the losses over the next few months. Warm weather is here but perhaps it is already priced into the market.

So in looking at the evidence at hand, the fundamentals are bearish and the technicals are overdone. I am holding my short in the February contract with a buy stop above.

Related ETF: Energy Select Sector SPDR (NYSEARCA:XLE)