Energy ETF XLE Struggles As Crude Oil Looks For A Bottom

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Summary

The XLE ETF, which tracks the S&P 500 Energy Select Sector Index, traded in direct correlation with the WTI crude price, is on the rebound.

The WTI crude price shows a direct correlation with the yield spread between the 10-year and 2-year U.S. Treasury Notes.

If the 10-year and 2-year yield spread rebounds, a bottom could be in for crude oil.

The share performances of the three largest holdings in the XLE are similar to the ETF, but decoupling started to appear or was an aberration.

The Energy Select Sector SPDR ETF (NYSEARCA:XLE), which tracks the S&P 500 Energy Select Sector Index (IXE) and is traded in direct correlation with the WTI crude price, is on the rebound after a sell-off in early November on concerns about global crude oversupply, financial turmoil in the eurozone and China, as well as a weakening U.S. economy now that the Federal Reserve has begun hiking interest rates. Investors appear to be reluctant to step in, considering that the crude oil market remains extremely volatile and the Fed rate hike path is ambiguous.

Comments and remarks from top OPEC and U.S. Federal Reserve officials usually move crude prices one way or the other. Recent remarks from Federal Reserve Chair Janet Yellen during her testimony in front of the U.S. Congress on February 11, sent the crude price plunging over 8% in just two days, to a 12-year low of $26.05 a barrel, while the yield spread between the 10-year and 2-year U.S. Treasury Notes dipped below 1 percentage point for the first time since early 2008. Investors may have a new worry about the sinking yield spread because falling spreads may indicate worsening economic conditions in the future. Since 1960, each time the yield spread went negative, a recession followed approximately 12 months later.

According to Bloomberg, Willem Buiter, Chief Economist at Citigroup, sent out a note to their clients to get ready for a global recession. "The most recent deterioration in the global outlook is due to a moderate worsening in the prospects for the advanced economies, a large increase in the uncertainty about the advanced economies' outlook (notably for the U.S.) and a tightening in financial conditions everywhere," said Buiter in his note.

Yield Spread and Crude Oil - There is no simple explanation for how crude oil prices, the U.S. dollar, and the bond yields are correlated. The general consensus is that crude oil prices move in inverse correlation with the U.S. dollar, meaning the crude oil prices would fall as the dollar strengthens, and vice versa.

According to Business Insider, a 2014 report by Goldman Sachs' Jeffrey Currie shows that such rationale has broken down in the wake of the American shale revolution. Currie explained that the U.S. net imports of crude oil have reduced significantly since 2008, as U.S. shale production has surged. This has "significantly reduced the correlation between commodities and the U.S. dollar," said Currie in his report.

WTIC vs Yield Spread Chart

Since early 2014, the WTI crude price has shown a direct correlation with the yield spread between the 10-year and 2-year U.S. Treasury Notes, meaning the crude oil prices have been falling as the yield spread narrows. A simple explanation would be that investors have backed off risky assets, including equities and commodities, on fears of a looming economic slowdown, sending yield spreads lower. As the Fed continues its path of aggressive rate hikes, the 10-year and 2-year yield spread will move towards zero, which puts downward pressure on crude prices.

10Y/2Y Yield Spread Chart

From our technical viewpoint, the 10-year and 2-year yield spread began tumbling from the 1.77 percentage point level when Fed Chair Janet Yellen made comments on July 15, during her semiannual testimony in front of the U.S. House Financial Services Committee, that the Fed was going to raise interest rates between September and December 2015. The 10-year and 2-year yield spread has fallen over 40% since then and is now supported by the lower trendline of a descending wedge chart pattern at 0.99 percentage point, or the 61.8% Fibonacci retracement level. If the trendline support doesn't hold, the next support will be at 0.86 percentage points.

In the event of a 10-year and 2-year yield spread rebound and a descending wedge chart pattern breakout for the price of WTI crude, a bottom could be in for crude oil. It might be a long shot though, as there is a major head resistance for the 10-year and 2-year yield spread at the 1.2 percentage point level, and several top Fed officials are still calling for aggressive rate hikes.

Fundamental and Technical Overview - About 42.98% of the holdings in the XLE ETF are the three big cap oil, gas and energy equipment and services companies, Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and Schlumberger (NYSE:SLB), with a combined market cap of over $590 billion, as of February 25.

XLE Technical Chart

Technically, the XLE ETF broke through the neckline of the head and shoulders chart pattern at the beginning of the year and overshot the downtrend channel. The XLE plunged to $49.93, but bounced off before retesting the October 2011 low of $49.63. Since then, the XLE has been moving in a bullish ascending triangle chart pattern, with a head resistance at around the $58 level. A breakout event could require the WTI crude oil price to move from the current level to between $35 a barrel and $37.50 a barrel.

Exxon Mobil - As of February 24, Exxon Mobil has a weight of 20.18% in XLE. Exxon Mobil Corporation announced revenues and earnings for the fourth quarter 2015 that beat consensus estimates. The company said it expects to cut capital spending by 25 percent in 2016 and suspended its long-standing share buyback program.

In early February, Standard & Poor's threatened to possibly cut Exxon's credit rating, one of only three corporate holders of a AAA bond rating. Analysts have raised concerns about the lack of information on the details of operating cost reductions and capital spending in Exxon's earnings announcement. Roger Read, oil analyst at Wells Fargo Securities told CNBC, "How much are you cutting your spending, what are you going to do to maintain the strength of your balance sheet, and where is production going?" "You didn't really get any of that with this press release," he said, but noted that Exxon typically delivers that data at its analyst meeting in March.

ExxonMobil Technical Chart

In our technical viewpoint, XOM decoupled from XLE in early December and has been moving in a symmetrical triangle chart pattern. Shares of Exxon Mobil broke through the 200-day moving average in early February and are now testing the upper trendline resistance of the symmetrical triangle. A reverse head and shoulders chart pattern, with a neckline at the $83 level has emerged. A breakout of the symmetrical triangle could take XOM to the $90 a share level.

Chevron - Chevron has a weight of 14.44% in XLE. Chevron reported a fourth quarter 2015 loss, despite Wall Street's expectations for a profit, citing plunging oil prices that eroded profitability across all its divisions. The bulk of Chevron's losses came from its divisions that explore for and produce oil and natural gas. Standard & Poor's also downgraded Chevron Corp. earlier in February.

"We're taking significant action to improve earnings and cash flow in this low price environment," John Watson, Chevron's chief executive, said in a press release.

To meet its goal of slashing capital spending by 24 percent in 2016, Chevron has reduced headcount, canceled drilling projects and frozen dividend payouts. The company has reiterated that the dividend remains its top priority, which will put more pressure on shares.

Chevron Technical Chart

From a technical viewpoint, similar to XOM, CVX decoupled from XLE in early December and has been moving in a symmetrical triangle chart pattern. Shares of Chevron are still trading under the major moving averages, which act as head resistances. CVX could pull back to $80 and $77.50 a share, if it fails to break out of the symmetrical triangle.

Schlumberger - As of February 24, Schlumberger has a weight of 8.37% in the XLE. Schlumberger reported fourth quarter 2015 earnings that beat expectations with revenues that were in line with analysts. The company faced a continued decline in rig activity, project delays and cancellations and other problems stemming from lower oil prices with no signs of pricing recovery in the short to medium term, it said in its earnings statement. In its press release, Schlumberger announced a new share repurchase program of $10 billion and that it approved a quarterly cash dividend of $0.50 per share.

Schlumberger Technical Chart

Technically, shares of Schlumberger are traded along with the XLE ETF. The decoupling of SLB from XLE in early February could be an aberration, meaning SLB could pull back. There are multiple head resistances, including the 200-day moving average, to overcome before the stock can move higher.

Conclusions - XLE, the Energy Select Sector SPDR ETF, which tracks the S&P 500 Energy Select Sector Index and traded in direct correlation with the WTI crude price, is on the rebound after a sell-off on concerns about global crude oversupply, financial turmoil in the eurozone and China, as well as a weakening U.S. economy. Since early 2014, the WTI crude price has shown a direct correlation with the yield spread between the 10-year and 2-year U.S. Treasury Notes, meaning the crude oil prices fall as the yield spread narrows. In the event of a 10-year and 2-year yield spread rebound, a bottom could be in for crude oil.

The 2-year share performances of the three largest holdings in the XLE ETF, Exxon Mobil, Chevron and Schlumberger are similar to that of XLE. Decoupling of the share performances of Exxon Mobil and Chevron and the XLE ETF started to appear in December. The decoupling of Schlumberger and the XLE shares could be an aberration.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.