Time To Dip A Toe Back Into The Ocean

Investors are generally better off paying little attention to weekly oil inventory and production figures. They can cause an immediate reaction in the oil markets, but can often send false signals. In addition, the implications of a weekly number are, by their very nature, short term. Over the last couple of weeks though, the numbers released by the IEA, and this week's report in particular, offer some encouraging news for energy investors.

Inventories climbed, for sure, and that marks the 15th consecutive week that inventories have remained above the eighty year high, which puts the current supply level into perspective. The rise, however, was less than expected and the production increase dipped below the short term moving average. Add to that strong demand, particularly for gasoline which was up over 4 percent year on year, and it hints that the worst may be over. That conclusion is certainly supported by the gradual recovery in oil prices.

That doesn’t mean, however, that caution should be thrown to the wind. There are some opportunities in Exploration and Production (E&P) companies, but bad news, of production cuts and downsizing is still dribbling out in some cases. Over the last month or so, I have recommended several plays with the proviso of small investments and fairly tight stop loss levels, and that strategy is still the best way to go, but it may be time to broaden the focus away from just fracking companies.

One other thing that should be taken into consideration here is that the oil price recovery we have seen in the last few months has yet to be fully replicated in the natural gas market. The U.S. land based shale oil and fracking companies that have led the decline are often more dependent on gas than oil, so recovery there is still nascent. A more pure oil play can be had by investing in offshore firms, where the ratio of oil recovered to gas is usually higher.

Deepwater rigs also generally have a high cost base too, so companies involved in that field have been particularly hard hit. From an optimistic perspective that means that if the recovery in oil is real and sustainable those companies have the most upside potential. Drilling stocks such as Noble (NE) and Seadrill (SDRL) have been hit extremely hard; NE is down roughly 60 percent and SDRL has lost around 80 percent from the highs last summer to the lows last month. Those summer levels may not be seen again for a while, if ever, but some kind of a bounce back looks likely, particularly if WTI breaks through $60. That feat looked highly unlikely just a couple of months ago, but now, in the $59s, it is starting to look inevitable.

In order to continue on up, the gains in both stocks derived from higher oil prices this week would have to be continued, so a stop loss just below the launch point for the recent strength makes sense. In the case of NE that equates to a stop at around $15.50 (potentially risking around 11 percent), and for SDRL at around $11 (risking 15 percent).

Those levels would be hit quickly if oil turns tail. If, on the other hand, the weekly inventory and production numbers really do mark the beginning of a trend reversal and the $60 level is broken to the top side, then both of these stocks will look ridiculously cheap at these levels in just a few short months. Right now, dipping a toe back into the ocean looks like a risk worth taking.