Why You Gotta Be So Crude?

This article was originally published on on November 7th at 4pm EDT

Is oil’s freefall over?

Today it seems the only story garnering front page headlines is what’s happening with the price of oil and what it means for the US economy—and its consumers and corporations. In the last year Brent Crude Oil has been as high as $115 and as low as $85 (where it is today).

While this type of volatility isn’t terribly unusual for the commodity, it is the rapid nature of oil’s decline since July that has many questioning what’s behind the one way move.

The possible catalysts:

– A stronger dollar
– A weakening global economy (i.e. Deflation)
– An increase in global production causing a supply glut

So, are any of these contributing factors? I think they probably all are. But they are all known. And knowns are priced in.

Lower oil prices have meant lower profit expectations for drillers and refiners, not to mention anybody selling services to drillers and refiners. As a result we’ve seen some pretty severe destruction in names like Chevron (CVX), ConocoPhillips (COP), ExxonMobil (XOM), and the index in which these are three of the largest holdings—the Energy Select Sector SPDR ETF (XLE).

Something interesting has happened the past three weeks—despite the continued decline in crude prices, we have seen a fairly substantial 8% bounce in the XLE, as you can see below:

It looks like the XLE did an about face after cratering by exactly 20%, right on October 14th. What caused the divergence?

On October 14th we saw intraday moves in both the XLE and the 10-year Treasury such that XLE’s annual yield eclipsed that of the “risk free” 10-year. Most likely what happened is algorithmic buying of energy stocks started on this basis, helping the energy sector avoid a technical bear market (a greater than 20% peak to trough move). Okay, great, but does this have any more meaningful relevance? It may….

Is the US Energy sector the tail that wags oil’s dog?

Over the past five years anyway, there has been a very strong, inverse correlation between the price of oil and XLE’s yield. In other words, as the price of oil has declined, so, too, have the stocks making up the energy sector ETF—creating buying opportunities for value investors seeking current income. These buying opportunities have tended to coincide with sharp turnarounds in the price of oil. And XLE’s current yield is higher today than at any point over the past five years. History is not our only guide, but it’s probably our strongest…

So who is profiting from oil’s decline?

Oil and other commodities are not often treated as an “investment,” per se. Investors, funds, and companies may place wagers on the price of oil as a hedge against inflation or deflation (depending on which way the bet is made), or as a hedge against their other investments—historically oil has a low correlation to stocks and bonds. As such, oil becoming less expensive does not appeal to value investors in the same manner as cheap stocks do. Value stocks pay dividends, which value investors like; owning oil does not.

Tough year for hedge funds.

For a variety of reasons, 2014 has been a tough year for hedge funds—big bets on interest rates, energy, and specific countries (Mexico, Russia, and Brazil) have not panned out. According to HFRX, the global hedge fund index is down so far this year, as the S&P is up almost double digits. But is it possible some of the biggest funds have their first profitable trade of the year betting correctly on a decline in oil?

I have no data to support this but my guess would be that a handful of large hedge funds have profitable short positions against crude right now. With XLE having turned around in the past week and oil appearing to have reached some form of capitulation (below), it would not surprise me to see some serious short covering. And we all know that in some instances selling begets selling—could the opposite hold true with short covering? Sure. Nobody wants to watch a profitable trade evaporate.

If I’m right, we could see a continued snapback in energy-related names, with the price of oil following. An even modest increase in the price of oil could lend further support to the S&P 500’s most beaten-down sector. Selling may beget selling, but buying begets buying….

If you have questions or would like to engage in a dialogue, please don’t hesitate to give us a call.

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on RealMoney can be found here.

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