Crude oil’s
fundamentals are extraordinarily bullish. Global demand for oil is growing
relentlessly, and most consumers have little choice but to pay virtually any
price for this critical fuel. Meanwhile
global production growth is slowing as old oilfields deplete and major new
finds become exceedingly rare.
This structural deficit has
driven oil prices to record highs, leading to fortunes earned by the
companies that produce this scarce and valuable commodity. Investors and speculators have
naturally migrated into oil stocks to ride this secular trend. But lately owning the oil stocks has
been an exercise in frustration.
On January 2nd, oil surged
3.4% to a record $99 per barrel. Yet
the oil stocks seemed to ignore this driver of their profits as the flagship
XOI oil-stock index lethargically hiccupped 0.2% higher. Then over the first three weeks of
January, the XOI plunged 16% far outpacing the general stock-market
slide. Yet oil averaged $94 on
close over this entire period, an extremely profitable level for the oil
producers.
To see oil stocks
struggling in the face of extraordinary oil prices has really fanned fears
among traders. If the oil stocks
can’t thrive in this environment, will they ever? And if long-term profits drive their
stock prices, why are they seemingly ignoring high oil prices which will
drive massive long-term
profits? Do weak oil stocks
betray a bearish structural problem in the world oil markets?
Thankfully nothing so dire
is necessary to justify the recent XOI weakness. The XOI’s
seemingly deviant behavior actually makes sense
when considering just how unique oil stocks are as a sector even among
commodities stocks. Instead of
serving one master, oil, they are constantly torn between two masters.
As the commodity bull
underlying a specific commodities-stock sector matures, the trading behavior of the stocks that produce this commodity
evolves. Initially off of secular
bear lows, no one is interested in the beaten-down stocks but hardcore
contrarians. They buy these
unpopular stocks when the commodity they produce rises. This creates a high correlation
between the commodity and the stocks that produce it.
And this is what traders
expect to see on a daily basis. If
oil rises then the oil stocks darned well better follow it higher! But as a sector bull matures, more and
more traders get interested in it and buy in. Eventually this once
contrarian-dominated sector becomes so widely-held that it goes mainstream. It
gradually becomes just another general stock-market sector highly correlated
with headline stock-index movements.
Unlike smaller sectors like
gold stocks still dominated by contrarians, oil stocks have gone mainstream. They
make up a large fraction of the S&P 500 (SPX) and virtually every
investor has some oil-stock exposure.
The money managers trading these stocks for their funds trade them as
merely another general stock sector.
They buy oil stocks when the stock markets rise and sell them when the
markets fall.
Thus oil-stock traders need
to understand that XOI performance is almost as dependent on the fortunes of
the SPX as it is on the fortunes of oil itself. If both oil and the SPX are strong,
the oil stocks should soar. But
if either oil or the stock markets
are weak, the XOI will struggle along.
Oil stocks, due to their massive size and widespread mainstream
ownership, are now torn between serving two masters.
In order to define
high-probability-for-success buy and sell points, oil-stock traders have to
simultaneously game the short-term trends in both crude oil and the general stock markets. Oil stocks were weak in early January
because the SPX was getting crushed, not because anything is wrong with them or
the oil markets. When timing
oil-stock trades, the high correlation between the XOI and SPX must always be considered as a major factor.
I’ve been studying
the interaction of the XOI with oil and the SPX since this oil-stock bull was
born, but haven’t written on it publically for several years. Since morale among oil-stock traders
is pretty low these days thanks to January’s XOI selloff,
I decided to update my research this week. It considers the behavior
of the XOI through the lenses of both the oil price and the SPX.
Today’s secular oil
bull launched in December 1998 when oil prices fell to a now unthinkable $11
per barrel! In the decade since,
the XOI did exhibit a strong positive daily correlation with the crude oil
price just as traders expect. The
correlation r-square over this entire span was a stellar 88.9%. In other words, 89% of the daily price
action in the XOI was statistically explainable by the daily price action in
crude oil.
But for my research this
week I’m more interested in how the XOI did during major moves in oil and the SPX. So in each of these charts I marked
off big swings in oil and the SPX to compare with the XOI’s
performance. For each big swing
in oil or the SPX, its gains/losses along with the XOI’s
gains/losses over the same time period are noted. Each swing’s correlation
r-square is also shown, with negative numbers representing underlying
negative correlations.
As you digest these charts, realize these big swings are optimized for oil
and the SPX, not the XOI. The
interim lows and highs used to measure the gains/losses are based off oil or
the SPX, with the XOI measured from the very same days. Thus these XOI gains/losses do not
reflect individual XOI uplegs and corrections, but
the XOI’s behavior
over precise oil and SPX big swings.
In order to explore the
influence of oil and the SPX on the XOI, this approach seems logical. In the future though I’d like to
further this research by looking at the XOI’s
correlations with oil and the SPX over exact XOI uplegs
and corrections, XOI-optimized. This
opposing perspective will help deepen our understanding of the reality of the
XOI’s constant battle between following oil
and following the SPX.
Provocatively between 1999
and 2002, oil stocks really didn’t follow oil all
that well. Oil soared 247%
in a mighty cyclical bull in 1999 and 2000, yet the XOI gained a trivial
23%. After mostly ignoring that
oil bull, the XOI also mostly ignored the following oil bear. Leading into late 2001 oil plunged
53%, but the XOI barely bled in sympathy with a trivial 11% loss. Oil stocks don’t always follow
oil prices.
In fact, from late 2001 to
early 2003 oil rocketed 116% higher.
You’d think that would really help the oil stocks, right? Interestingly the XOI actually fell 12% over this same period of
time. If you think January 2008
was a tough time to own oil stocks, that was nothing compared to 2002. Not surprisingly the culprit weighing
on oil stocks in both periods was identical, a weak SPX.
Over the past decade the XOI’s daily correlation r-square with the SPX was
only 31%, far lower than the XOI/oil’s 89%. Yet this low correlation is somewhat
misleading, as there were two very distinct periods of XOI/SPX
correlation. The first one prior
to the end of the SPX’s cyclical bear in late 2002 witnessed very low
correlations, while the second one since late 2002 witnessed very high
correlations.
Leading into the SPX
secular top in early 2000, the XOI mostly ignored the stock bull. Oil prices were dismally low and
traders were enamored with “new
economy” stocks anyway. Who
wanted to own old-economy oil stocks when high-flying Internet stocks were
soaring? Not really participating
in the bull, and hence not getting overbought, the XOI was able to largely
ignore the resulting SPX bear too.
It only fell 10% compared to 49% for the SPX and they were totally
uncorrelated on a daily basis.
But if you look closely at
the red SPX and blue XOI lines above in 2001 and 2002, there is definite
influence from time to time. On a
short-term basis the XOI was weakest when the SPX was plunging into its sharp
V-bounces marking the ends of its major downlegs. Even back then, before oil stocks were
as widely-held as today, they still had a strong tendency to get sucked into
any serious general stock selling.
But since that SPX bear
bottomed in late 2002, the XOI/SPX correlation r-square has soared above
90%! This is very high and means
that 90% of the daily up-and-down action in the XOI was statistically
explainable by the daily action in the SPX. Interestingly the XOI didn’t
just pace the SPX bull, the XOI amplified it considerably. It soared 244% from late 2002 to late
2007 compared to just 102% for the SPX.
This offers a very
important lesson for investors. If
you expect a cyclical bull in the SPX, you’ll probably make a lot more
money in oil stocks than in general stocks. Not only are the underlying oil
fundamentals more bullish than almost any other sector’s underlying
fundamentals, but oil stocks still trade at P/E ratios well below the general
market’s. They’re a
bargain. At the end of January
2008, the XOI was only trading at 10.6x earnings compared to 18.7x on the SPX!
Financial and technology
stocks are a whole lot sexier than oil stocks, no doubt. But financial and technology products
can be easily replicated as the barriers to entry for competitors are
relatively low. If prices of
products soar, new competitors spring up within months to erode sector
profits. Meanwhile it takes years
or decades to find new oil deposits and bring them into production, no matter how high oil prices go. So big oil companies face far less
competition for fat profits than any other sector.
After this strategic
perspective on XOI correlations with oil and the SPX over a decade’s
worth of big swings, I wanted to zoom into the dazzling bull markets of the
last five years. It was a
fantastic environment for the oil stocks, with both oil and the SPX rising
relentlessly on balance. Since
2003 the XOI’s correlation r-square with oil
ran 89.4% compared to 89.9% for the SPX.
So both key drivers were very important for XOI performance.
The r-squares of the XOI to
oil’s big swings since early 2003 are generally pretty high. And indeed visually the XOI seems to
closely follow the oil price most of the time. Any r-square over 65% or so (a 0.80+
positive underlying correlation) is important for traders to consider. Since the XOI is this highly
positively correlated with oil, gaming the
short-term oil trend is obviously critical to success in oil-stock trading.
But if you look carefully,
there are certainly exceptions to the rule of the XOI following oil most of
the time. In late 2004, oil
surged dramatically yet the XOI largely ignored it and barely budged. In mid-2006, the XOI fell sharply
despite oil merely grinding sideways near record highs. In late 2006, the XOI actually rose to
new highs of its own despite oil plunging. So there is plenty of precedent for
the XOI ignoring oil from time to time.
And if you investigate
these seemingly anomalous episodes when oil doesn’t drive the XOI,
including January 2008, the vast majority of the time the SPX is the
culprit. The XOI plunged in mid-2006 in sympathy with a
sharp selloff in the SPX. As just another sector widely held by
mainstreamers, professionals dumped oil stocks just like everything else when
the markets started looking scary.
And in late 2006 the XOI
surged because the SPX was soaring higher. Mainstream money managers were pouring
capital into oil stocks despite the sharp oil correction so the XOI
rose. Late in this brutal
correction during its terminal plunge into January 2007 the XOI started
following oil again, but only briefly.
At any given time the SPX seems to have almost as good of chance of
driving the XOI as oil itself.
This next chart views the
XOI bull market since early 2003 from the perspective of the SPX. I found these two bull charts to be
the most valuable and useful when considered simultaneously. Just like the XOI followed oil most of
the time in the chart above, it follows the SPX much of the time in this
chart. And whenever the XOI
diverges from the SPX for a season, oil is usually the cause.
By this particular division
of major SPX uplegs, the average XOI r-square with
the SPX in its uplegs ran 69.5%. This is considerably lower than the
78.9% average from the previous chart’s rendering of major oil uplegs. So
despite the SPX’s slightly higher r-square (89.9% vs. 89.4%) over this
entire span, oil is still more important as an XOI driver than the SPX. Indeed this is also evident visually,
as the XOI and SPX lines are not quite as tight as the XOI and oil lines.
The biggest short-term
divergences seen here are all the result of oil. They include the XOI surge in early
2005 despite a flat SPX and the sharp XOI corrections in mid- and late 2006
despite a surging SPX. So if you
are a mainstream money manager or stock trader and you see the XOI not
performing as you expect relative to the SPX, look to oil for answers.
The most fascinating
portion of these two charts occurred between the third quarter of 2006 and
the first quarter of 2007. A
peculiar combination of circumstances drove oil to plunge in its biggest correction of this bull
while the SPX simultaneously surged in its biggest rally since 2003. So what did the XOI do with its two
primary drivers diverging so wildly?
It carefully trod the middle path between both!
Look at this specific
Q3’06 to Q1’07 period while scrolling back and forth between
these last two charts. The XOI
performed far better than oil reflecting the SPX rally’s positive
influence but far worse than the SPX reflecting oil’s negative
influence. The XOI was struggling
to serve two masters, doing neither one justice but instead waffling between
them. If you want to trade oil
stocks, you have to weigh the SPX’s fortunes almost as heavily as
oil’s.
The best of all worlds is
when both oil and the SPX are rising.
Mainstream capital floods into oil stocks as index funds buy all the
stocks of the SPX, including the oil majors. Meanwhile commodities-oriented funds
park larger fractions of their capital in oil stocks to ride oil’s
underlying gains. The result is
oil stocks rise with, and nicely amplify, the underlying gains in both oil
and the SPX.
But if either oil or the
SPX is weak, oil stocks won’t fare as well. In situations where the weak driver is
just gradually grinding lower, the
XOI can often ignore it or even overcome it and latch on to its other strong
driver. But if either driver is plunging, the fear
rapidly spreads to oil stocks. So
if you see oil or the SPX plunge in a sharp correction, expect the XOI to get
dragged down with it even if the other driver is doing well.
And if both oil and the SPX
plunge sharply, the oil stocks are going to get slaughtered. If you ever expect an oil correction
to happen to line up temporally with an SPX correction, just get out of
oil-stock trading positions and consider gaming the
short side. Just as oil stocks
tend to rise way faster than the SPX when oil is strong, they tend to fall
way faster than the SPX when oil is weak. Profits leverage is a sharp
double-edged sword.
As lifelong students of the
markets at Zeal, we try to consider all material factors driving commodities
stocks. For the larger sectors,
general stock-market performance is crucial. We launch new trades accordingly based
on how all these factors, including the oft-overlooked ones, are lining
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The bottom line is oil
stocks are not solely driven by oil.
The larger a sector gets, the bigger the market capitalizations of its
companies and the more traders who own them, the more general stock-market
action also drives this sector’s performance. In order to successfully trade these
sectors, both the underlying commodity price and general stock-market action
must be actively gamed.
In the case of oil stocks,
they still have a higher correlation with oil which is logical since it
drives their ultimate long-term profits.
But they also have a high correlation with the SPX which can really
affect them over the short term. So
if you traffic in oil stocks, realize that they are sometimes torn between
serving two masters. Don’t
trade them in a vacuum without considering prevailing stock-market trends.
Adam Hamilton, CPA
Zealllc.com
Fébruary 16, 2008
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