Regular readers know that commodities and their related stocks aren’t usually my focus. Despite my tourist status, I have had some views on crude oil weakness since the end of 2014. Those views have remained steadfast and have helped guide my world view from an investment standpoint.
Here are some of the views I’ve held on Crude Oil weakness over the last year and change:
- has NOT merely been the result of global oversupply as so many have suggested since its 2014 highs,
- is NOT a boon for U.S. consumers and retailers,
- has been the first wave of an unwind resulting from the U.S. Fed ending of years of QE,
- dividend cuts, credit defaults and bankruptcies DO pose a potential contagion risk as so much energy related debt is dollar denominated, sovereign in places like Brazil and a shit ton comes due in 2016
- will likely need to see some sort of capitulation selling to form a bottom, likely with a 2 handle
Many of these views were out of consensus in the first half of 2015, but became more mainstream in the back half of the year. I have no idea how or why oil bottoms, and it could be similar to 2009 iff China’s economy were to turn, which was the impetus for the bottom then. Regardless I suspect it comes from lower levels. I do believe that long oil or some high quality related stocks will be a great contrarian long trade in 2016, and timing will be key.
Back on December 2nd when the XLE, the Energy Select etf which 40% of its weight comes from Exxon (XOM), Chevron (CVX) and Schlumberger (SLB), I tool a look at the technical set up, when the etf was above $65, now $59.50:
From oil’s most recent top in 2014, the XLE has not been able to make a meaningful break above the downtrend (that has been in place since June 2014). The downtrend line has been the spot for short entries or take off long exposure in oil stocks:
Obviously the XLE failed at the downtrend and is now below important near term support at $60:
I guess the most important takeaway here is that XOM, the largest holding at 18.5% of the weight of the XLE, and CVX at 14.5% are 15% and 25% off of their 52 week and multi-years lows respectively, showing dramatic relative strength to the broader group of stocks that make up the XLE.
There are two ways to think about this. First, the weaker players are being priced for lower oil for longer and the potential for dividend cuts, credit defaults and possibly bankruptcies in 2016. If this worst case scenario happens then mega cap stocks that have acted okay on a relative basis will play catch up to the downside, and the concentration of investors hiding out in these stocks could exacerbate this move. But I will tell you that if oil were to put in a stealthy bottom in the coming months, things could get interesting in large integrated oil companies like XOM and CVX because they’ve already been priced for some worst case scenarios.
For instance, consensus estimates are calling for a 50% and 65% year over year earnings declines in earnings for XOM and CVX respectively for 2015, back in 2009 XOM’s earnings declined 53% & CVX’s 50%. We are likely to reach an earnings trough in 2016. On a pure valuation basis, the decline in earnings have caused both stocks to look particularly expensive, with XOM’s P/E matching its 2009 high and CVX exceeding, trading 20x and 25x respectively on a trailing basis. I guess I’d rather take a shot on the long side at some point in the XLE from lower levels than any one of its large components.
But let’s look at the long term technical set up, which for the time being looks a bit nasty. As my friend Carter Worth, technician extraordinaire from Cornerstone Research likes to say, “draw the lines anyway you want, but this is the way I see them”. The XLE is quickly approaching the long term uptrend that has been in place since the etf’s inception back in 2002. A bounce could come down near the uptrend in the mid $50s, but there is little support below that till $50, and oops, then $40:
So What’s the Trade?
XLE is at a potential inflection point and the next move, higher or lower could be swift. Taking a stance in the etf itself in either direction (long or short the underlying) seems to carry unnecessary risks. Implied vol in the options are high on a one year basis, but actually fair relative to its movement since the summer. Therefore it’s possible to define your risk while taking advantage of reasonable options pricing. We want to offer a couple ways to play from defined risk directional basis depending on one’s current positioning or directional bias:
Outright Bullish/ or Stock Alternative:
Buy the XLE ($60) Jan/Jun 67 Call calendar for $1.20
-Sell to open 1 January 67 call at 32 cents
-Buy to open 1 June 67 call for 1.52
Break-Even on January Expiration:
Max gain at $67 or slightly lower. At that point the Jan call would expire worthless, and you would have an increase in premium in the June call that you are long, and have lessened your break-even on June. At that point we would look to sell another out of the money call, possibly in a different expiration and make another calendar, or sell a higher strike call in June expiration and make a vertical.
Rationale: We are generally not fans of out of the money long premium directional trades. In this case we like the idea of playing for a sharp reversal over the next 3 to months, but are obviously unsure on timing and from what level. The calendar trade structure serves to help offset some decay and becomes a manageable long over time with rolls possible.
OR
Outright Bearish/ or Hedge:
Buy the XLE ($60) March 60/45 put spread for $3
-Buy to open March 60 put for 3.40
-Sell to open March 45 put at 40 cents
Break-even on March Expiration:
Profits: of up to 12 between 57 and 45 with max gain of 12 at 45 or lower.
Losses: up to 3 between 57 and 60 with max loss of 3, or 5% above $60
Rationale: I’ll offer a similar caveat as above, we generally don’t like long premium directional trades in etfs or stocks where options prices are elevated, and definitely not where the break-even is out of the money. In this case implied vol in March at the money puts seems quite reasonable at 29%, very near the average of the last 5 months. For those who are convicted on the prospects for lower lows in oil stocks, but want to define their risk to express this view, near the money puts look attractive, while selling out of the money puts to help off set a bit of decay make sense.