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Over the last several weeks, in both the daily blog and weekly newsletter, I have been laying out the technical case for a breakout above the downtrend. As I stated, while such a breakout would demand a subsequent increase in equity risk in portfolios, I didn’t like it. To wit:
“First, let’s remember that the current advance is not built on improving economic or fundamental data. It is built simply on ‘hope.’
With valuations expensive, markets overbought, volatility low, and sentiment pushing back into more extreme territory, there are a lot of things that can go wrong.
As shown below, the recent surge in asset prices has also turned the 50-dma sharply higher and is in the position of crossing back above the 200-dma. It is worth noting that the last time this occurred, it did fail shortly thereafter.”
“I can’t really explain the current rally. All I know is that prices are dictating policy at the moment. We can deny it. We can rail against it. We can call it a conspiracy.
But in the “other” famous words of Bill Clinton: “What is…is.”
The markets are currently betting the economy will begin to accelerate later this year. The “hope” that Central Bank actions will indeed spark inflationary pressures and economic growth is a tall order to fill considering it hasn’t worked anywhere previously. If Central Banks are indeed able to keep asset prices inflated long enough for the fundamentals to catch up with the “fantasy” – it will be a first in recorded human history.
My logic suggests that sooner rather than later somebody will yell ‘fire’ in this very crowded theater. When that will be is anyone’s guess.
In other words, this is all probably a ‘trap.'”
While I did increase equity exposure following the breakout above 2080, I strongly remind you that I am keeping very close stops AND do expect to be “stopped out.”
With the FOMC back on deck this week, it is quite likely that if Janet Yellen has another “When Dove’s Cry” moment, stocks could push towards previous highs. We will re-evaluate our equity exposure again at the point.
Oil – Is It Time To Sell
While we wait, let’s turn our attention to the recent surge in oil prices. Is it too late to buy into the Energy sector at this stage? Or, is it time to sell?
In a nutshell, the very easy near-term gains have likely already been seen. As I will explain below, the fundamental and technical backdrop suggests that for patient, long-term investors there will be plenty of opportunity to pick up oil/energy exposure at cheaper levels in the months ahead.
First, let’s take a look at the fundamental backdrop of oil – supply and demand.
Oil’s Supply Still Outstripping Demand
Sheraz Mian at Zacks.com recently penned:
“Oil is a global commodity, it’s price determined by the interplay of supply and demand forces worldwide. The demand side of the equation is relatively straight forward, driven as it is by global economic growth. This growth has been most visible over the past decade in the emerging world, particularly China.
Demand from the developed world as a whole, primarily the U.S., Europe and Japan has largely been flat to down. For example, the consumption of oil from the OECD group, a developed world grouping that includes the U.S., Europe, and Japan, in the 10 years through the end of 2015 dropped by a cumulative -4.7%. A combination of efficiency gains for these economies and stricter fuel consumption standards drove this decline, a trend that will likely continue in the coming years as well. During that same time period (from 2005 through 2015), China’s cumulative oil consumption experienced a +64.4% jump, making China the world’s second largest consumer of oil behind the U.S. Demand for other major emerging economies like India, Brazil and Indonesia similarly increased. With the Chinese economy now past its break-neck speed phase, it’s oil demand growth has started slowing down as a result.
The combined effect of this flat-to-down OECD demand and decelerating demand growth from China and other emerging economies has resulted in slower demand growth for oil.“
The chart below shows the long-term supply/demand balance for oil going back to 1980.
The 12-month average rate of consumption has declined in recent months and, as Sheraz correctly stated, more fuel efficient cars, homes, transportation, etc., combined with weaker global growth rates, will likely continue to push demand lower in the future.
This slip in demand comes at a time when supplies have once again reached record levels. This surge in supply is a direct result of the innovations in oilfield extraction techniques, “fracking,” which was driven by a boom in liquidity provided by the Federal Reserve. The chart below shows the relationship between oil prices and the increase the in the Federal Reserve balance sheet.
The induction of liquidity into the financial system by the Federal Reserve translated into an effective “land rush” for oil companies to form drilling partnerships. The inevitable consequence of a malinvestment boom are now being felt as roughly 1/3rd of the companies that leveraged up to chase speculative oil production fields will eventually go away.
With the shift in dynamics by the “fracking miracle” which began in 2009, the U.S. in now able to economically produce more oil out of the Shale basins than ever before. Even with the decline in rig counts, the efficiency of oil extraction out of producing wells is keeping supplies still well elevated.
“U.S. oil production reached an all-time low in late 2008 as the global financial crisis got underway. But volumes have steadily increased since the 2008 bottom, surpassing the peak reached in 1970 last year. Production peaked in 2015 and has been coming down since then. But the incremental jump in U.S. production from the 2008 bottom to the 2015 peak is in excess of 5 million barrels per day of new oil, which is more than most OPEC members’ total production, save for a few.“
Take The Money And Run
With supply and demand imbalance likely to remain for years to come, it is very likely that we will once again return to a long period of volatile prices within a very confined range as seen during the 1980-1990’s. Therefore, for those wanting to invest in oil and energy related positions, the shorter-term price dynamics are going to be substantially more important.
If we take a look at the “Commitment Of Traders” report we see that exuberance over the recent surge in energy prices has pushed the number of oil contracts back to the second highest levels on record.
As with the past, these surges in contracts have typically denoted short-term peaks in oil prices. This time is likely going to be no different.
There is also a direct correlation between these oil contracts and the financial markets. As of late, it has truly been “so goes oil, so goes the market.”
Furthermore, oil prices are no extremely extended on a price basis with prices now deviated more than 12% above their 60-day average.
The same is true if we step this out further to a 3-month basis and look at the rate of change in prices over that period. The current level is consistent with previous short-term peaks in oil prices.
Lastly, on a purely technical basis, prices are now extremely overbought on WEEKLY measures. Such overbought conditions rarely last long and a correction is needed before a further price advance can be entertained.
What To Do Now
This brings us back to our question: Is it time to sell energy related exposure?
Given the fundamental weakness in the economic environment, an inability of suppliers to substantially reduce production as revenue is needed to meet debt servicing requirements, and a gross short-term extension in prices – the answer is most likely “yes.”
The recent run-up in oil prices was a product of extreme oversold conditions and a massive short-covering rally induced by the realization that the Federal Reserve will not, as expected, raise interest rates at any point this year. The decline in the US dollar also provided a substantial tailwind.
However, with the dollar now over as well, short-covering completed as oil contracts have surged to near all-time highs, there is a distinct possibility of a decline in oil/energy related positions as we head into the summer months.
Given the fundamental weakness in energy-related companies, in terms of earnings and profits, the safest place to “hide” in the sector, if you must have exposure to energy, is in the mega-cap refiners such as Exxon and Chevron. However, even these companies will suffer a price decline when oil prices revert back towards $30/bbl this summer.
Oil drilling companies are the most susceptible to price volatility and many in this space will likely face bankruptcy risks in the months ahead. There is also substantial risk of “reversions” in the Master Limited Partnership space as parent companies reacquire their pipelines for the much needed cash flows. We just saw this earlier this year with Linn Energy and should expect to see more in the future.
Be careful of what you own and where.
There is still risk in the sector longer-term as hopes of a quick return to $80/bbl fades into a reality the “new normal” may be much lower.
Lastly, and most importantly, if you are still holding onto energy-related positions at a 30-60% loss or more, sell them for the loss and re-evaluate what you are doing.
If you have an advisor, then it may be time to find a new one that actually understands the importance of “capital preservation.” The excuse of “we like energy and think it will come back” is not money management – it is “hope” and “getting back to even” is not an investment strategy that will work out for you longer term.
There is one simple truth about investing in anything long-term – you want to “buy it” when nobody else “wants it.”
That is not the case currently as too many investors are still operating on a “recency bias” hoping that with oil today at a level last seen following the financial crisis will result in a similar outcome. That is extremely wishful thinking given the completely inverted supply-demand dynamics, global economic weakness, and a pending economic recession.
Don’t get caught hoping.
Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In