High Volatility Highlights Opportunity In Energy Stocks

Attempting to trade or invest in the energy sector on long-term fundamentals has been a tricky proposition lately. Oil futures, and therefore most energy stocks have been bouncing around, driven by headlines about international trade, U.S. politics, and escalating conflict in the Middle East. Over time though, the short-term effects of those headlines will be outweighed by the medium to long-term trends inherent in the underlying stories, and that makes it worth returning to an old favorite stock for trading, both long and short, Transocean (RIG).

What makes RIG attractive as a trading vehicle is that its low price (around $4.60 at the time of writing) and high volatility (it recently gained around 50% in just over two weeks, then lost 50% on a retracement) make it effectively like an option on itself. Of course, while that creates the potential for great returns, it also increases risk, but that makes it the ideal candidate for the kind of trade I like, with strictly adhered to, tight stops and a good risk/reward ratio.

Before we get into the technical aspect of those levels, let's look at why there is a medium-term bull case to be made for the stock.

Transocean specializes in offshore oil exploration and production, a sub-section of E&P that has been out of favor for a while. Improved fracking technology and a White House and EPA that are open to expansion of onshore drilling have significantly lessened demand for relatively expensive to recover offshore oil. That explains why RIG's one-year chart looks like this…

At this point, it is reasonable to assume that those factors are fully priced in, and maybe even overly so. It would only take a small change in the outlook to prompt the kind of bounce that we saw from 8/16 to 9/16 of this year. That change could come from the thing that on the surface least impacts oil fundamentals, U.S. politics.

It has been a bad week for Donald Trump, with the whistleblower allegations concerning his relationship with Ukraine prompting the launch of a formal impeachment inquiry by Congressional Democrats. The initial reactions to the story highlight the problems in American politics at the moment. When the story broke, and long before any details were known or evidence seen, both sides jumped to conclusions. The Democrats decided that it was grounds for impeachment, while Mitch McConnell, the Republican Leader of the Senate, declared that there was no chance of a conviction when and if a resolution is passed and it goes to a vote there. How they arrived at those conclusions without seeing any evidence is mystifying, but I guess that's just where we are at.

The Republican fait accompli makes it highly unlikely that anything concrete will come of this, but as the inquiry proceeds it will bring an air of uncertainty about the next election. That could be enough to help RIG in itself, but it will also provide a good incentive for some good news on trade, which would boost energy stocks generally.

On the other hand, good news regarding the Middle East conflict is highly unlikely. Even if the Saudis do meet their optimistic forecast for restoring full production following the drone attack by the Yemeni rebels, or by Iran if you prefer, the attack highlights the vulnerability of oilfields and the fact that they are now considered a legitimate target. With no sign of an end to the conflict, the possibility of another attack should at least limit oil's downside.

None of this is certain to happen, nor is it sure to happen soon, which is why it is especially important on a trade like this to have a convenient, relatively inexpensive stop-loss level. Fortunately, the chart for RIG shows one at the moment.

If you chart the Fibonacci retracement levels for RIG, as on the above chart, you will see that we are close to a 78.6% retracement of the upward move at $4.38. A stop just below that at say $4.28 would limit potential losses to around 7%. The initial target would be for a bounce back to the 23.6% retracement level at $5.97, giving a targeted upside of nearly 30%. I would add a caveat to that target level. If we get above the 50-day MA, currently at $5.10, I would adjust the stop upwards to lock in a small profit at worst.

Essentially, what you are looking at here is a play on a possible bounce in oil. Technical analysis of the futures market suggests that there is a good chance of that too.

Early Friday morning, CL bounced off the bottom of a downward trend line and regained its own 50-day MA. If that holds, a move back up looks to be on the cards.

So, with the chance of a short-term, technical boost from oil prices, and a longer-term fundamental picture that could also lend support, buying RIG here is a decent trade. It has a good risk/reward ratio and relatively low downside, and that is just the kind of thing I like!