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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Can Energy Stocks Break Out Of Their Range?

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After last year’s rapid recovery from the depths of the oil market’s plunge, many investors went into 2017 expecting black gold to keep rising in value. So far, it is not working out that way. The energy markets have been sideways at best for most of 2017, and energy firms as a whole are not performing all that well.

The Energy Select Spdr ETF (XLE) encapsulates this issue well – XLE is down to around $72 a share versus north of $78 in December. The ETF is a good broad measure for most of the energy stocks out there. Despite the fact that oil itself has only fallen modestly, many energy firms have underperformed in the market over the last few months.

The underperformance of energy stocks may be because investors expected oil prices to keep rising, and the current price level is still too low for most stocks to make much money. Or it could be that the equity market investors are simply more pessimistic than commodities players are.

Whatever the reason, at least over the last few months, the energy trade is not working out the way many investors had hoped. For now, the easy gains seem to be gone, leaving investors to wonder what they should do from here.

The outlook for oil for the rest of 2017 is decidedly uncertain and the case for further price increases is getting weaker. While OPEC has shown remarkable discipline in its supply cuts, investors must be wondering whether the Cartel is still as relevant as they once were.

The U.S. is producing markedly more oil than it was a few months ago, and shale drillers are just starting to come back into growth mode en masse. Moreover, U.S. producers are now operationally stronger, more efficient, and better at coping with low prices than they were a few years ago. All of this may well lead to the U.S. regaining its crown as the world’s largest oil producer.

Equally importantly, news came out on Thursday that Russian supply cuts are not materializing to the degree that was expected. Russia’s February output was unchanged versus January at 11.11 million barrels per day. That corresponds to price cuts of 100,000 barrels – one-third of what Russia promised OPEC. The Russian failure might start to undermine compliance across OPEC and spell serious trouble for the Cartel’s cohesion.

The case for oil prices rising from here rests largely on significant demand by speculators, a recovering global economy, and unusually large maintenance outages from Asian refining operations in the Spring. These factors may or may not be enough to boost oil during the rest of 2017 – the outlook from here is balanced which is why oil has not moved much of late.

Against this backdrop investors need to tailor their investments accordingly. In particular, investors have to contend with the possibility that many energy firm stocks are going to struggle going forward unless oil prices break out to the upside.

Investors should be looking at the strongest companies in the space. Oil companies that score high on value metrics at this stage are probably also value traps in many cases. The market is rewarding those firms with the most feasible production by giving them higher valuations. Those stocks with strong price momentum are likely to do well going forward based on the historical evidence.

Investors who are not comfortable betting on stocks that have already run higher might consider looking at various options strategies as an alternative. Straddles and calendar spreads both look like attractive strategies in the current environment. Straddles should benefit once oil breaks out in either direction, while calendar spreads offer a great way to mitigate overall market exposure while still benefiting from higher volatility down the road in oil and energy stocks as a whole.

Whatever strategy energy investors choose to adopt, it is clear that the energy market recovery story is looking a lot shakier than it did three months ago.

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