Energy Markets Vs. Energy Companies

Includes: OIL, USO, XLE
by: Jeff Malec

A couple of weeks ago we discussed the volatility contraction of the crude oil market, and how it could mean an outlier move ahead. And close on the heels of that were two of the best in the financial blogosphere, Reformed Broker and All Star Charts, with posts recently on the energy "sector" possibly starting to outperform the general market after being a card carrying underperformer since the beginning of 2012. Here's the two charts showing the energy sector relative to the overall S&P (essentially dividing the price of the energy by the price of the overall stock market index).

(Charts Courtesy: Reformed Broker and All Star Charts)

Now, you could be forgiven for thinking that the energy sector has been going down for most of the past five years from looking at the charts above - but those charts depict relative performance. The energy sector (via the ETF XLE) has actually done quite well since the 2009 lows, see here:

(Chart Courtesy: Finviz)

Those are two very different looking sets of charts, to be sure - with the relative performance trending down and the absolute performance going steadily up (now we know why there's billions traded around relative value strategies in the hedge fund world). The different look in the first set reflects that the energy sector (i.e. energy companies) haven't seen their stock prices rise as much as the overall market, not having anything to do with iPhones, electric cars, biotech, real estate, or streaming movies - until now, Brown and Parets point out. Turns out there's more than a few people taking notice of this trade - take a look at just how much money went into both the XLE and USO ETF's just last week (April 18th-24th).

(Table Courtesy: Hard Asset Investor)

And here's where things get interesting - because the energy market itself, you know - the price of the stuff they pull out of the ground and from 2,000 feet below the bottom of the ocean, doesn't look like either of those charts, with crude failing to recapture its 2008 highs even while the XLE has surged about 15% above its '08 highs. Here's what the price of crude oil has looked like since the 2009 lows.

(Data Courtesy: Quandl)

We would expect a high correlation between energy prices and energy company stock prices, and while they both climbed off the 2009 lows in near lockstep - the price action of the last few years has been anything but correlated, with energy companies up about 30% since 2011 and crude oil basically flat over the same time period. Which brings us back to the relative performance of the energy sector to the overall market… it has been the range bound conditions in the energy markets since 2011 which have kept the lid on the energy sector (on a relative basis). A rising tide lifts all boats, and investors have been willing to buy up stock in energy companies along with the general market, despite crude oil lagging behind… but only to an extent.

So, from our seats - whether the breakout in relative performance of the energy sector continues depends in large part on whether crude oil can finally break out of its multi-year consolidation pattern. A breakout to the upside could provide that extra bit of incentive which has been dragging on its relative performance for the past few years. And of course - remember that relative performance has a bit of a mortal flaw as well - if not using it as a pairs trade and actually going short one of the pairs.

If the general stock market is going down more than the energy sector is going down, guess what - they are both going down, so it may be of little comfort for those owning XLE to have a nice relative strength breakout in energy - resulting in them losing less than the general market. We would rather be exposed to something which can actually make money when the market (be it stocks or energy) go down.

PS - if you think USO is ever a good idea, compare its price action since 2006 to the charts above. There's almost no relation due to the high roll yield cost the fund pays in the futures markets.

(Chart Courtesy: Finviz)