A Dash of Insight

Energy Opportunity

Oil futures had a knee-jerk reaction today as the market factored in a decline in air travel and jet fuel consumption.  Since many hedge fund managers trade energy ETF's as if they were proxies for oil futures, this may provide an opportunity.  The reaction is based upon a directional decision, not an assessment of the fundamentals.

The reasons for selling include factors that are all subject to question, something I described on our energy site.

The opportunity for investors depends upon how one views the upstream versus downstream energy companies.  The behavior follows the Cobweb Model, where reaction depends upon how the companies needing new production view the future of demand.

The next question is how to interpret the behavior of the "big uglies" as some call the integrated oil companies.  There is evidence that their announced capex expenditures may not lead to major increases in supply.

We can review this by looking at what major integrated oils are actually doing on capex.  ExxonMobil is a good example.

My conclusion is that E&P companies, despite the recent lackluster performance, are only reflecting oil prices of $40/barrel or so.

Investment in ETF's has distorted this market, presenting an opportunity to investors who understand how upstream and downstream really works.  Full disclosure --- my funds and investors have some energy positions in these holdings.  This has been a good move -- at least until very recently.  Over the last two years any decline has provided a good opportunity to add.  Since the fundamentals look the same, I seek to add to my positions with some new names.

More Overreaction in Energy Stocks

The higher volatility in these stocks makes no sense, but it comes with the territory.  Here's the story, and I'll explain more below.

Link: Energy ETFs Leak Oil.

Bloomberg reports that Crude oil fell on expectations that milder temperatures in the U.S. will help preserve stockpiles of winter heating fuels that are above average levels. Warmer weather is forecast for most of the U.S., with temperatures in...

Energy Trading - Background

There is so much attention on oil prices that it seems like CNBC has become the Energy Channel.  It is not surprising.  The energy "sector" is up over 20% on the year and also accounts for the largest segment of earnings growth.  The S&P uses the term "sector" as it is defined in Morgan Stanley Capital International's Global Industry Classification Standard (GICS).

Many -- perhaps most -- of those in the parade of talking heads on CNBC, and online pundits as well, talk about energy in this same broad fashion.  Everyone wants to act informed, including those who paid little attention to energy stocks before this year.  The result is that nearly everyone says things like "You have to own energy," or "We like the energy names," or "We have been doing well in energy."

Our own sector definitions are much narrower, more like the sub-industries in the GICS system.  For trading purposes these definitions are much sharper.  Here's why.

The broad energy sector as defined in the GICS system includes a wide range of companies including the following:

• Companies that own oil reserves
• Companies that explore for oil
• Companies that build exploration equipment
• Natural gas and pipeline companies
• Refiners - who buy oil from others and sell a finished product
• Shippers - who transport either crude or refined products
• Large integrated oil companies who do most or all of these things

The S&P 500 includes 28 companies covering the gamut listed above.

These companies do not all benefit in the same way from changes in oil prices.  Those that have large reserves will benefit from higher long-term prices when they sell the reserves.  More important for stock valuation is the impact on earnings.  A spike in prices may be good for the integrated companies, but have no real implications for the drillers or oil services companies.

More later..