About three months ago, we reiterated our longstanding bullish call on oil and energy stocks. That bullish view looks timelier than ever now. Both oil and energy stocks are getting a sizable boost from current events.
And speaking of current events: If you’re worried about the state of the world right now, energy stocks could be an extra favorable place to allocate some capital. That’s because they are benefiting from the recent unsettling headlines, rather than being hurt by them.
Here’s an example of what I mean: Oil prices surged earlier this week on two pieces of news. Saudi Arabia intercepted a missile over Riyadh, and the United States appeared to confront Russia with a warning it would fire missiles at Syria.
These events set off a scramble to buy call options on crude oil futures. (Call options make a profit when prices go higher.) The “call skew” for West Texas Intermediate Crude, which is a measure of how expensive call options are versus put options, shot to its highest levels since June of 2014 on the Syria and Saudi Arabia news.
The last time the call skew was this bullish, the price of oil was $105 a barrel.
In plain English, this means geopolitical concerns are putting a “fear premium” back into the crude oil price. For quite a while, this fear premium had gone away because the world was awash in crude oil.
But that glut of extra oil has almost disappeared…
Excess oil inventories are now at their lowest levels in more than three years. This is partly because Saudi Arabia and Russia, along with OPEC, have successfully cut back production to try and get the oil price up. The Saudis are reportedly targeting $80 a barrel.
So, a combination of rising geopolitical fears (Syria concerns, tension in the Middle East) and falling levels of excess supply (which acts as a cushion against shocks) are helping the oil price. This in turn is longer-term bullish for energy stocks, as higher crude oil prices mean fatter profit margins for the oil industry.
You can see the favorable picture for crude oil in the chart below. Crude oil is rising from an extended period of sideways consolidation that lasted more than a year.
But it’s not just oil itself that is looking bullish. Energy stocks are also in a bullish position.
You can see this below via the chart of XLE, the popular energy stock ETF. There was a powerful upside breakout in XLE coming off significant levels of volume-at-price (VAP) support. This suggests a new upside move for energy stocks could be underway.
There is at least one more bullish factor at work for energy stocks. The CEOs of oil and gas companies have moved away from a “produce at all costs” mentality and are focused more on cash flow and making sure their projects stay profitable. The days of “drill, baby drill” have been replaced by more conservative efforts to preserve capital and make sure that projects are worth the money.
This is visible via the outperformance of the conservatively managed ConocoPhillips (COP), a major US oil producer that has outperformed its peer group and also beaten the S&P handily over the past year.
The management team running COP decided to focus on reducing size and emphasizing share buybacks over aggressive growth, and investors have rewarded COP with superior share performance versus its major oil competitors.
Other oil companies have gotten the message and are following suit, focusing on cash flow and profits rather than spending. Shale companies are also more cautious and profit-oriented than in days past – again because investors have essentially said to them, “no more throwing money away on expensive or risky projects.” This is good for share prices.
All of this comes together to reinforce our bullish view of both oil and energy stocks (a view we have held for quite some time).
Even if tensions in the Middle East continue to rise, and even as other areas of the market fall out of favor (like the FANG stocks), crude oil could continue rising. And energy stocks, now under more conservative management and moving higher, look set to benefit from that trend.
Have a good weekend.
Richard Smith, PhD
CEO & Founder, TradeSmith