A Trading Strategy For Earnings Season

It's that time of the quarter again! Earnings season is well underway, and we will see fourth quarter 2017 results from many energy companies next week. Friday will bring a few "big oil" results, with reports from Exxon Mobil (XOM) and Chevron (CVX) as well as Phillips 66 (PSX), so now is a good time to take a look at what to expect, and to look at the best strategy for traders going into the releases.

The consensus forecasts for XOM, CVX and PSX are for earnings per share of $1.03, $1.06, and $0.87 respectively. Not surprisingly given that oil spent almost the entire quarter marching up, all those numbers represent a significant improvement on the same quarter in 2016. What matters in an earnings release, however, is how the company performs relative to those estimates rather than versus last year. On that basis too though, there is evidence that going into earnings long of all three stocks makes sense.

First and foremost, you should keep in mind that on average around two thirds of companies' earnings beat expectations. I have written on that subject here before, but it is a product of the tendency of CEOs to try and under-promise and over-deliver, and the fact that analysts naturally base their estimates off corporate guidance, at least to some degree. Add in the fact that for those analysts missed opportunity for their clients due to underestimating earnings is a lot better than those clients losing money due to an over-optimistic forecast, and it is no surprise that estimates tend to miss on the low side.

Still, my dealing room background makes me cautious of running a position into any major data release, and, with oil companies in particular, there are a lot of variables that can cause a stock to drop on earnings, even if the EPS number itself is a beat. That is why I rarely go in with a position, preferring instead to trade the reaction rather than the news. This quarter I will make an exception.

The reason is not just because Q4 was a period of rising prices. It is also because those prices have continued to climb, increasing the chances of positive forward guidance to go along with good results. The stock market is usually more concerned with the future than the past, so positive outlooks could cause stocks to pop, even if the backward-looking results don't please.

Based on what we have seen so far this earnings season though, that looks unlikely. Just yesterday, for example, Caterpillar (CAT), whose business relies to some extent on optimism in the oil and gas businesses, knocked it out of the park with EPS of $2.16 versus expectations for $1.79 and issued an improved guidance for 2018. That not only suggests strength in energy and materials generally, but also indicates that despite some upward revisions to estimates the analysts are still behind the curve when it comes to Q4 earnings in general.

For the integrated multinational firms such as XOM and CVX, of course, there are many things that could offset that. Exxon has recently shown a tendency to underperform, so a case could be made for leaving that stock out, even if you agree with the basic case laid out above. Even so, that is reflected in the fact that estimates there represent only about eighteen percent YoY growth as opposed to say Chevron, where earnings are expected to grow from $0.22 last year to $1.33. On that basis, it is easy to make a case that XOM represents perhaps the biggest potential for an upside surprise.

As I said, I usually don't like running a position through earnings, but there are plenty of indications that a series of beats and upbeat guidance by big oil companies is on the cards, making an aggressive strategy warranted this time around.