17 Sep No, It’s Not Too Late To Buy Oil Stocks
The attack on Saudi oil fields was, of course, unexpected. But this oil-positive news came after oil stocks were already in the midst of their best month since January 2019. The S&P Oil & Gas Exploration & Production Index (XOP) was already up +8.58 for September before the attacks. As is often the case, news follows price. Our investment hypothesis today is that Energy stock prices will not fade, as has been so often the case. This is the Energy rally to buy into.
We have seen all the experts make scenario forecasts on what will happen to oil prices based on the length of the outage. We won’t comment of oil price forecasts here. The bottom line for us is that oil prices will now reflect a geopolitical risk premium going forward. And these rising higher prices will boost profitability and free cash flow of the Oilers enormously. Just as investors like to hold gold to protect against overall economic risk, holding West Texas crude oil (WTI) contracts or oil stocks will afford protection against Middle East geopolitical risks. Oil prices have always been sensitive to supply disruptions in the Middle East – investors, in general, just got complacent about these geopolitical risks.
At the same time, the global economic slowdown should limit demand for oil above $65 / barrel. Oil prices may just prove to be an additional drag on anemic world GDP growth. This would still be bullish for Energy stocks, until a recession slow both consumer and industrial demand for oil as well.
An even more bullish scenario for Energy stocks is a re-acceleration of the global economic with crude oil prices that remain lofty. The recent decline in global demand for oil resulting from trade war concerns will reverse as soon as there are agreements between the US and China, Japan, Canada and Mexico. Demand in this case will support West Texas crude oil above $65/barrel and the Energy companies will finally see profit-driven growth.
We are also dubious on the argument that U.S. energy production will maintain over-supply conditions. Believing that shale production will be ramped up again ignores the fundamental reasons why shale drilling has significantly receded over the past year, which is that capex is being withheld while debts are paid down and share buy-backs offer better ROI. Prices for $WTI will have to be above 75/bbl for companies to return to drilling. Meanwhile they are drawing down reserves to meet demand, which is a short-term solution.
At the micro level, we can again argue for higher oil prices and Energy stocks. Balance sheets of many of the smaller Oilers, like Baytex (BTE), are in rapid transformation with huge increases in free cash flow and earnings. After the recent turn higher, which appears to be for real, investors are typically behind the curve. As their risk appetite expands, sellers withdraw offers and share prices rise. Many of these companies could have 3x increases in share price in the next six months based on fundamentals driven changes in investor sentiment that will reverse the price controlling algorithms.
Finally, the Saudi Aramco IPO is only going to go forward if oil prices remain robust. It is in the interest of Saudi Arabia to support the higher oil prices we are seeing on Monday to get the IPO done.
News Following Price
The Saudi oil attacks, as mentioned above, occurred as oil and Energy stocks were already setting up for a rally. We track the two main Energy sector indexes, the S&P Oil & Gas Exploration & Production Index (XOP) and the S&P Oil & Gas Equipment & Services Index (XES). In the charts below, we show how these Energy indexes have been setting up for a major up-cycle.
First, sentiment towards West Texas crude oil sank to almost 6-years lows. The Crude Oil Commitments of Traders report from the CFTC show speculative net shorts were not betting on oil bouncing. At market turning points, the speculators are always wrong.
Next, the price charts of XOP and XES were signalling a reversal in price. The XOP returned this past August to the same $20 floor that caught the price fall in 2009 and in 2016. After both tests of the $20 level in 2009 and 2016, the XOP enjoyed over +100% gains.
The XOP also was setting up positive divergences between the oscillators (RSI, Stochastic, and MACD) and price. Positive divergences such as with the stochastic shown below, typically are resolved by seeing price reverse higher.
The XES has fallen so much that we wonder if *anyone* is still long the index of Equipment and Services companies.
We see the same positive divernces on the XES. Note also that 2018 drop in price did not result in positive diverfgences with the oscillors. As shown in red in the RSI (top) and Stochastic (bottom) charts, the osciallros confirmed the falling prices in 2018. And the early 2019 rally in the XES indeed petered out.