A Sad Tale Of Oil Markets - And Oil Stocks

Includes: APC, CVX, OXY, XLE
by: Daniel Dicker

Oil/oil stock correlations have broken down.

Even with the support of oil prices, oil stocks have become an utter minefield.

The Occidental deal remains the canary in the coalmine - and the canary is coughing badly.

Oil traders are facing a very sorry place, and it's even worse if you concentrate in trading oil stocks and advising others on the energy sector, as I do.

So much is currently broken, but there is one and only one chart that must be first on your mind today if you’re trying to invest in oil stocks:

Here's a simple representation showing oil prices since the start of the year in RED -- and oil stocks represented by the XLE oil stocks ETF in BLUE

What’s clear is that the relationship between oil and oil stocks, one that I’ve relied upon for my whole career in timing investments, is currently KAPUT. No matter how well you understand the myriad other inputs that go into making investment choices in oil companies, this chart alone makes those decisions a complete minefield. How can you buy oil stocks if they won't react positively to rising oil prices? The answer is: You CAN'T.

And, if you're looking through my lens, there are other, almost equally difficult charts to view the markets through that are just as distressing. Here's a chart of speculative activity which I almost always consult before making any investment decision:

There is nothing more bullish for oil, in my view, than if speculative positions have recently emptied out and have just begun to attract fresh new interest, as you can see happened at the beginning of the year. But, just as negative is to see those bullish positions begin to be exited after reaching a fair height, as we're seeing beginning to happen right now.

You want more? Ok, let's look at this one, which is related to the last in several ways: Here's a representation of the movement of the curve of oil prices over the last several months. You can see that prices have moved rather quickly from a condition where front prices were cheaper than back prices (contango) to a condition where front prices are more expensive (backwardation). This quick turnaround in spreads got several watchers and hedge funds in a bit of a panic, as they interpreted this switcheroo as a coming prompt barrel shortage. Many of the long positions that were accumulated in the last two months in the last chart probably did so because of the action of the spreads represented in the chart above.

Well, I've seen price curves change for 35 years now and it's true that a move like we've had *could* indicate a prompt shortage, but it certainly doesn't have to. Plus, the 6-month backwardation that we've seen of about four dollars isn't really all *that* deep, historically speaking. More likely that many commercial hedgers were locking in some 4th quarter prices after the nice rally we've seen this year, as well as some long specs who were jumping on the momentum bandwagon, pushing the backwardation out a bit.

But when that hoped for, expected follow-thru didn't come in oil prices based on the backwardated curve, conviction in the inevitable shortage among traders weakened, another reason we've seen positions exited recently with the current drop in oil price. Not surprisingly, we've also seen the backwardation of the curve begin to moderate as well. All to say that in oil, one should never base their investment decisions upon just one theory or one chart alone......you'll almost always get bitten.

Finally, of course, there is Trump and the trade war, where a single tweet can sink any investment, no matter how well it's been thought out.

So, lots of negative trends - of which importantly NONE are really fundamental - have been plaguing oil and oil stocks. And in the last two years, these have been the most important trends to watch, where, dependent upon which direction they are headed, have indicated either an 'all-in' or 'all-out' investment mood. There's been surprisingly little in between action.

The Occidental/Anadarko deal is without doubt the best indicator of just how binary and difficult the markets have become. Both Vicki Hollub at Occidental and Michael Wirth at Chevron have decided (independently?) to buck the current negative trends and believe that Anadarko was suddenly deserving of a 40% premium. I've called Anadarko the ugly 'queen' of the ugly ball; no better or worse than several other independent E+P's out there. Meanwhile, Mr. Market seems to agree with me as oil stocks continue to act terribly. Not even Warren Buffet, with his $10b cash infusion, is really showing support for anything but his sweet 8% preferred OXY stock, exactly the game he's played successfully in the past with Goldman Sachs in 2009. His sidekick, Charlie Munger, admitted they both otherwise don’t know a thing about shale.

But the timing of the deal is very, very useful, if only to focus our attention to the primary question for investing in oil companies right now. Which is: Is Hollub right? Is the divergence of oil (going higher at least since the start of the year) and oil stocks (going nowhere no matter what) indicating an opportunity to find value in some oil companies at huge discounts, at least to historic oil prices? Or is shale proving itself to be a continuing cash sinkhole, that looks likely to get worse? (at least until it gets better).

My thoughts are as they have always been throughout my trading career; I will never ignore the most important trends that I have seen help successfully time my investments in the oil space, including the ones I have outlined here. My conclusion is that I cannot look favorably on high beta oil companies while speculators are in the process of bailing on long oil futures positions - as that is a trend likely to work against stock prices for several weeks. I also cannot rationally buy oil companies while their stock prices continue to diverge from oil prices - as even a quality rally in oil might not lead to much progress for the underlying stocks. And finally, it's tough to recommend much in the space while the President can (and often has) submarined those investments with a single tweet. No matter what fundamental positives can be found for oil stocks, these trends remain far to difficult to battle against.

For now, oil stocks are nothing but a sad tale of frustration to be avoided.

Disclosure: I am/we are long OXY. 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.