Different Cycle, Same Gimmicks. A Bearish View of the Energy Sector
Oct 31, 2021 Trading Blog
I’m starting to disconnect with the larger Twitter bullish opinion of the energy sector. I can feel it. I feel myself moving toward a bearish bias, however there’s not much factual evidence to support that position – yet. Everyone around me is bullish and every piece of information they present is bullish. But the question is this: Is all of this bullishness around me simply confirmation bias gone wild? Is it the blind leading the blind? Is it simply peer pressure between participants resulting in the fact that nobody is brave enough to be bearish and that everyone has accepted the mantra that “stonks only go up”?
I’ve traded this sector for a long time and I’ve seen several cycles from top to bottom. And every time it ends up being the same story. Everything looks like roses, all the information is positive, all the numbers are good. And then, on dime, it’s not. The key is knowing when things change. Sometimes knowing when things change is simply intuition, not cold hard facts. There are certain things that have happened at every top and every bottom. This week I saw one of those things and it set off my bearish alarm.
Almost every earnings report so far has included a company raising dividends, promoting buybacks and cutting capex. These facts seem bullish, but in the larger context, are they? Many think so, and they are buying with both hands. But, after trading this sector for several cycles and seeing things that happen at the top each time, we may be closer to the top of the cycle than many people think.
At this point you really have to ask yourself, is increasing dividends really the best use of (temporary?) cash flow? Probably not. Paying down debt would be much better, especially as we head into a much higher rate environment. How about increasing capex? They aren’t doing that either. Why not? Is the oil business so bad that there’s just no use in reinvesting the money back into the business? This seems to suggest that these companies don’t believe oil prices will remain at a level that can support more investment now or in the future. If they truly thought oil prices were going to remain higher for longer, the correct path is to SLOWLY increase capex to balance increasing profits and prop oil prices. Yet they aren’t doing that because they know oil prices can’t handle it.
Everyone is aware of the mistakes that have been made as oil companies have underinvested. So they are choosing to continue to underinvest now and instead just give that cash away? We all know that the underinvestment is what has propped up oil prices, but is underinvestment really the best option for the longer term health of the sector and oil itself? At some point, all the underinvestment will make oil so expensive that the green energy movement wins by default. It also produces energy prices that are so high that it chokes off the demand that produced those higher prices in the first place. High energy prices have led to more than one recession which kills demand and causes oil crashes. In the bigger picture is decreasing capex and increasing dividends really the best way to go for future health? Probably not.
Which leads me to this question: Why increase dividends and buybacks but refuse to increase capex or pay down debt? Paying down debt and reinvesting in your core business is clearly the better choice for the long term. The oil business has been a huge borrower in the past, and will continue to be a huge borrower again in the future. Free cash flow won’t last in this boom or bust industry, it never does. They sure aren’t doing anything to put away some cash for a rainy day or extinguish their current liabilities. Ignoring the normal oil cycle is reckless. So instead of paying off debt, they are putting themselves on the hook for MORE debt at higher rates? Not a good long term decision.
Increasing dividend obligations at the top of the oil price cycle is quite obviously not the best long term decision either. There have been years where companies like Exxon have had to borrow to pay the dividend. So now they are going to INCREASE that obligation into an oil price that is possibly already extended and possibly put themselves on the hook for that increased dividend borrowing to occur again, but this time in a much higher rate environment? Not smart.
So why are they focusing on the short term and making decisions that are so obviously incorrect in the longer term? Because it’s what Wall Street wants NOW. It’s simply a tactic to make the stocks look better today. Unload at the top of the cycle. It’s a sales gimmick that works great for the short term and it has happened in every past cycle. It’s a great sales pitch that allows current holders to unload right into an oblivious public who only sees facts and ignores the larger context. Larger players can see the current confirmation bias. They know this class of investors from the last ten years believes “stonks only go up”, and they are taking full advantage of those biases right now. These gifts of higher dividends come with a big hidden cost. As the old saying goes, “Be cautious of those bearing gifts”.
So if intuition is correct and these gimmicks are the sign of the top of the cycle, the next question is where is the exact top? How long does all this short term “feel good” news last? How long to investors stay gullible? When does oil price roll over and when do these new buyers realize that their stocks have just increased their obligations right into a declining (possibly crashing?) oil price and rising interest rates? It’s a very difficult question, mostly because there’s a force at play that hasn’t been there in past cycles – a tidal wave of free money from the FED. But that could also be changing soon.
We’re going to get a good look at the FED this week. If there’s a hawkish surprise, energy stocks and other commodity stocks could get hit hard. It’s no secret that inflation is rising. At some point, we will hit a tipping point where inflation will cause more harm to the economy than good, and the FED will be forced to act. The taper may start, rates may rise, the dollar may strengthen. We could go from Goldilocks to a nightmare really quickly. Keep an eye on the USD/CAD and gold this week, they will give some good clues on the dollar. If the dollar does start to strengthen, see if that corresponds to a pullback in oil, as it usually does.
And then there’s oil itself and the media’s portrayal of the great “energy shortage”. There’s a huge difference between a real shortage and a manufactured one. Is there really a shortage or is this a manipulated scheme orchestrated by OPEC, and supported by the media, to prop prices up? Is it a trap to entice US shale into overextending itself? At what point does OPEC pull the rug? Because they can. The oil is out there, just sitting there, and all they have to do is open the tap. It’s a shortage that could end on a single OPEC PR. Just look at the OPEC/Russia strategy and tactics of March 2020. Will you be fast enough to escape what that would do to energy stocks?
We’ve also got an overall market that is running hot, almost parabolic even. How long can this continue? How quickly does it correct and how severe is that going to be? When does this market have a blowoff event which leads to an extended downturn? If the economy stalls and causes a market correction, energy stocks could be one of the first classes thrown overboard. As has been the case many times in the past, energy names lead near the end of the economic cycle. As with energy, the overall market is much closer to the top than it is to the bottom. Again, when it inevitable correction comes, will you be fast enough to get out with profits intact?
As for the energy sector itself, I keep seeing all these people claiming the sector is so hot and outperforming. Is it really? You know where XLE was on day one of the pandemic (February 21,2020)? 58.06. You know where we are now? 57.47. The XLE is actually LOWER now than it was before the pandemic started. Ask yourself why and then look at what the rest of the market has done since February 21, 2020. Yeah, sure, every guru says they are up 1000%+, but are they really? It’s somewhat amusing how they all moved their portfolio start date to April 2020. Why do you think they did that? Is that what’s produced the “hotness” and “outperformance” that everyone is screaming about? What kind of returns do they really have, knowing that most of these guys are long term players who were holding a full portfolio just prior to February 21, 2020? Look, I know a lot of people who have made good money in energy, but don’t confuse “outperformance” with simply buying a sector as it laid cold on its deathbed. The easy money was made, now we get to find out if this is all real and if there is any future in it. I don’t think there is as much future in oil as most seem to think. Be careful of all the bullish claims and hype going on around you, most of it is the result of getting lucky catching a huge dip, because in the bigger picture, we’re right back where we started.
In addition, the technical picture isn’t that great, nor is the risk reward of a long trade at this XLE level. I’m not saying a long trade can’t win here, what I’m saying is that it’s an incredibly expensive proposition, and one that’s likely better left alone. I’ve posted the weekly chart going back about 10 years several times on Twitter. From April 2020 until present, we simply moved through a low liquidity area, and even that was a struggle. That struggle has only brought us back to day one of the pandemic. Compare that to where the SPY is. If you look at that weekly chart, there’s about ten years of supply sitting right overhead. The XLE stayed in a range of 60-80 from 2011 to just before the pandemic. The collapse began near 60. We are right back to that level and there could be a huge amount of holders who are just glad to get back to even. They could clog the upward price movement as they try to escape these positions. At best, the XLE has a maximum move to 80, which is about 30%. Most likely, 70 is the true upside, which is about a 15% gain. That’s your best case. What’s your worst case risk percentage loss if it all goes bad? Way more. Getting long heavily at these levels is just not that great of a risk/reward play. If anything, let it pull back some and shift the odds more in your favor.
Look, I’m not saying sell it all and get short here. I’m saying that we are much closer to the top than we are to the bottom. The wild bullishness we are seeing now could very well be wrong. The subtle clues are there. Now is NOT the time to be pushing all the chips in long. That opportunity has long since passed. What I’m saying is start to get a little cautious here. Tighten your stops and protect yourself. Trim some profits and lock them up. Basically, I’m saying to be aware of the confirmation bias occurring all around you. Twitter is an echo chamber for the most part. Everyone is excited, everyone is talking their book, yet very few of these people have seen multiple oil price / energy stock cycles and almost nobody will take a stance opposite the majority. Be curious. Ask yourself why these decisions are being made by oil companies. Are these decisions being made for short term greed or long term health?
I hate to be so negative on energy, but that’s just the way I see it right now from the longer term perspective. I’ll still be trading intraday in both directions, but as usual, I favor the small bites in this kind of environment rather than the longer term larger plays. Now it’s time to wash away all this negativity with a couple bottles of wine and some live music. Hope the rest of your weekend is great, enjoy it with some friends or family. Good luck this week.