Risk of energy trade

The Risks To The Energy Trade

Volatility remained elevated this week after the equity market meltdown last week. The VIX volatility index, which had remained in the 10-15 range over the summer months, has now held above 17 the past two weeks. Markets have moved to Risk-Off mode. October has been diabolic for killing equity bull markets, notably in October 1987 and October 2007. Market news was light over the week with earnings announcements driving individual stock prices. The apparent Saudi Arabia state assassination of a Washington Post journalist in Istanbul, followed by U.S. threats of sanctions against the Kingdom, didn’t even support oil prices, which have been pulling back since the beginning of October. U.S. 10-Year Treasury yields have held around 3.20% since spiking higher on October 3rd. At the same time, the S&P 500 drop stabilized with interest rates this past week. The beginning of earnings season calmed – temporarily – anxieties, with some big names announcing results beating estimates. As we have been witing in our Daily Updates, we don’t expect a rapid return to equity record highs, despite having seen extreme oversold conditions last week.

Macroeconomic news this week was mixed. As far as good macro numbers go, the Philly Fed Business Outlook Index came in at 22.2 in October, above the estimate for 20.0, and the Leading Economic Index (LEI) increased +0.5% in September after +0.4% the prior month. Industrial production increased +0.3% in September, in-line with the consensus. Now the bad news. Retail sales disappointed in September, only increasing +0.1% versus +0.6% expected. Ex-autos, retail sales fell -0.1%. But what stuck out this week was the continuing deterioration of housing data. Housing Starts slipped -5.3% in September while Building Permits dropped -0.6%. Existing Home Sales also disappointed, falling -3.4% in September versus an estimate of only -0.9%. The housing industry companies have seriously diverged from the broad stock market. Below is the S&P Home Builders Index (XHB). Is this a sign that recession is near?

Risks For The Energy Sector

A couple weeks ago in our Commentary “The Commodity Super Cycle”, we enumerated the reasons why we like the Energy trade at this stage of the business cycle. Today, we look at what could go wrong with an investment in the Energy Sector today. As risk managers, our job is to remain vigilant to changes in economic conditions that could impact our investment hypothesis.

The first and most obvious risk to our preferred scenario is that crude oil does not get to $100/barrel. We don’t want to be trying to predict or forecast where oil prices are going. Right now the data suggests that oil prices should continue to rise. If the oil data changes, we must change our positive energy outlook.

We remain optimistic on seeing $100 oil based on prevailing supply and demand conditions. OECD crude oil inventories have fallen below the five-year average, as shown in the chart below.

It is unclear how inventories will build again. OPEC is maintaining production cuts and Iraq oil risks to stay off the market with U.S. sanctions. A major oil discovery could bring new supply to the market. However it would take years to put this into production. Oil prices would not likely fall in the near-term on this supply concern either.

Another potential source of supply could come from U.S. fracking. But again, we don’t believe that reopening fracking drills will add sufficient capacity to put downward pressure on oil prices.

Finally, producers are balking at increasing production in today’s price environment, whether for political reasons (i.e., Russia / Saudi Arabia / OPEC), economic (shareholders demanding lower growth and higher returns), or both. Even if production picks up, oil prices may not drop in the short run, given the lag between ramping production and final delivery. In sum, we don’t see any supply-side factors that could drive up oil prices at this time.

A second risk to Energy is if the Federal Reserve rate hikes push short-term rates above the inflation rate. This will juice the U.S. dollar and hurt commodity prices. While this risk of rising rates/strong dollar is real, this would hit all sectors, not just energy. And given the deep value most energy company stocks are enjoying, it seems unlikely that rate jitters will cause investors to sell under-valued stocks before their overvalued stocks.

Indeed, there is s margin of safely built into Energy company stocks trading at bear market valuations. We have seen that historically, assets that are down 80% (as in the case today with many Energy and Mining companies), tend to have average 3-year nominal returns of 172%.

Any investment strategy comports risk. It is for this reason we earn return. We like Energy much more than the broad equity market. If oil prices plummet and/or the U.S. dollar surges, we have risk management tools in place. We constantly monitor supply/demand pressures in the oil market. At the company level, weekly verification of company fundamentals ensures no companies in the portfolio see downward revisions in earnings and sales. Finally daily surveillance of the stock prices with our Trading Models will keep us out of the under-performing names.


Our Energy investments will eventually rise not because we’re optimists; they’ll rise because improving fundamentals will compel market participants to take notice. Once they notice, investor psychology will compel them to participate. We are still in a momentum market and the algos continue to send money into the richest stocks. Energy investors much remain patient. Momentum will eventually turn in favor of Energy and valuations will again become a topic of discussion.

Trade Recommendation

This week we added exposure to the Philippines and Indonesian stocks market to our global DGR Strategy. Both countries are attractively valued, especially relative to the U.S. stock market. Recent pull-backs in both the Philippines and Indonesian stocks market have created a buying opportunity. In addition, on the Philippine Composite Index, we see an attractive positive divergence with the oscillators (RSI, Stochastic, MACD).

In addition, both the Philippines Peso and Indonesian Rupiah are screaming cheap versus the U.S. dollar. Below we again see a negative divergence in favor of the Rupiah against the dollar.

We took positions in the MSCI Philippines ETF (EPHE) and MSCI Indonesia ETF (EIDO).

This Friday our QQQ options expired deep in-the-money. We made +283% on the QQQ put options.


Like to give your opinion? Join our Community Discussion