Energy Stocks Are In Need Of A Rest
Summary & Key Takeaways
In light of the recent outperformance of energy stocks, the sector looks to be in need of a period of consolidation.
As such, we may be entering a period whereby the oil price itself outperforms energy companies. Depending on one’s timeframe, investors may do well to take profits in energy stocks.
Longer-term, the bull case for energy stocks remains intact and investors would be wise to maintain a long-term allocation to the sector.
Are energy stocks set to underperform?
Earlier this week, I detailed why I remain bullish on oil and energy across both the medium and long-term (you can read all about this here. Spoiler; it is still a good time to be long energy). However, upon conducting this analysis, what crossed my eye are the number of signs suggesting oil stocks may be in need to a rest and look set to both underperform their commodity counterparts but perhaps the broad equity market itself in the coming months.
For energy bulls and stock market aficionados alike, the vast outperformance of energy companies over the past 12 to 18 months should not be of news to you. However, one particular dynamic that may just be is how much energy stocks across the entire sector have outperformed the oil price itself of late. This is true for exploration and production companies along with refining, oil servicing and energy infrastructure companies alike. Generally, energy stocks tend to trade in tandem with the oil price and any divergences are usually short lived. Given how energy stocks are effectively a high-beta play on the underlying commodity in that their fundamentals are leveraged to the price of oil (a dynamic being particularly pertinent for exploration and production companies), it is usually the oil price that leads the way.
Should this relationship continue to hold true then there is clear potential for a bit of catch-up or catch-down type move in the coming months whereby the commodity itself outperforms oil stocks. My base case is that these two probably meet somewhere in the middle whereby the stocks correct and the commodity gains.
The potential for this outcome is perhaps even more likely if we see some form of slowdown in the draining of the Strategic Petroleum Reserve now the mid-term elections are out of the way and political incentives potentially shifting. This very notion may speak as to why oil stocks have seen such outperformance relative to the oil price lately, as we can see opined below by Warren Pies, a preeminent energy analyst.
As noted by Warren, stocks may have already priced in any slowdown in the SPR release given their discounting nature.
An important development also in confirmation of this dynamics is the recent action of corporate insiders within the energy sector. For the most part, there is not a truer representation of the smart-money than the executives and managers within a particular company itself. Indeed, there are few who understand the intricacies, business developments and fundamental outlook for a particular company or sector better. When an array of company executives within a particular sector or individual company is buying stock hand over fist or inversely selling down their holdings, it pays to pay attention.
Nowhere has monitoring the actions of corporate insider borne more fruit than within the energy sector over the past decade, particularly given the sectors cyclical and capital-intensive nature. As we can see below, the insider buy/sell ratio (inverted) for the sector is far from bullish and if anything, is at bearish levels given the new highs in price have seen corporate executives significantly reduce their holdings. This is evident for both the energy sector itself and on a relative basis compared to the insider buy/sell ratio for the broad stock market.
This is not to say corporate executives within the energy sector are no longer bullish long-term, but perhaps is merely confirming the notion that energy stocks may have gone too far too soon and in need of consolidation or correction.
From a technical perspective this notion again seems apparent. If we chart the relative price action of the energy sector versus the S&P 500, following a near tripling in outperformance since late 2020, the latest move higher in relative price has been rejected at an important overhead resistance level around 0.18 whilst also being accompanied by significant bearish divergences in the RSI and MACD indicators. There technical conditions generally resolve from consolidation or pull-pack in price, though nothing is so easily guaranteed in markets.
The technical picture of the energy sector itself is similar. The recent price action in the XLE ETF was rejected around the $90-$92 area coinciding with the June highs, while coming on the back of a daily 9-13-19 DeMark sequential sell signal. Perhaps a pull back to the $85 support level or even the 50-day moving average is in order.
What’s more, the recent high was not confirmed by a new high in breadth, here measured via the number of individual stocks within the XLE ETF trading above their 50-day moving averages. Such bearish divergences also tend to precede short-term reversals in price.
A similar technical dynamic can be observed for the XOP ETF, consisting of the exploration and production companies within the oil and gas sector. Here illustrated via the weekly chart, the recent rally up to the $160 area is both a key resistance level that dates back to 2015 and was accompanied by bearish divergences in both RSI and MACD. Unless we see a breakout above this level that would nullify these bearish divergences, we could see price fall all the way back down to support around $110. Though such a significant pullback appears unlikely however given the favourable long-term fundamentals of the sector. If this were to occur it would be a screaming buy.
Digging further into the technical weeds, we can see below how the energy infrastructure ETF (ENFR), oil refiners ETF (CRAK) and oil services ETF (OIH) are all too butting heads with overhead technical resistance.
From the perspective of some of the individual supermajor energy companies themselves, it is notable how Exxon Mobil has recently broken out of its ascending wedge pattern. Such a technical structure is generally considered to be a short-term bearish reversal pattern, and when accompanied by a daily 9-13-19 DeMark sequential sell signal and a small divergence in momentum (RSI), this seems suggestive of trend exhaustion for the stock. A pull back to the $102 area/50-day moving average appears a plausible outcome.
Similarly, Chevron’s technical picture is nearly identical, with the $165/50-day moving average area looking like a level in which we could see any correction run its course.
No reason to fret for the long-term
From a longer-term perspective, similar to my outlook for oil and energy commodities themselves, I remain bullish.
Although we could see a period of underperformance for energy stocks relative to the broad stock market as discussed, if history is any guide, then this outcome is likely to be short lived. When charting the relative performance of energy stocks versus the S&P 500 to the oil price as well as analysing the forward P/E spread between the two, energy stocks appear to still be greatly undervalued.
Source: @JesseFelder, @SoberLook
We can also observe this dynamic by comparing the relative earnings of the energy sector versus the S&P 500, which again suggests there to be plenty of upside performance for energy over the coming years given their superior fundamental position.
Indeed, energy stocks are flush with cash. We are seeing free cash flow for many companies beginning to exceed levels seen at the height of the early 2008 peak in oil, largely a result of a lack of any meaningful pick-up in capital expenditures. As I discussed here, oil prices are likely to continue to rise until we see any form of progression in the capital cycle. This is not yet the case.
If only from a diversification perspective, energy stocks remain a good bet and an excellent area to allocate capital.
Clearly, the long-term outlook for energy remains attractive and as such we are likely to see energy stocks outperform the broad market going forward. Despite what could be a forthcoming period of underperformance, we must remember that all good bull markets need consolidation.
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