Attempting to pick the bottom of oil’s move down has so far proven to be an expensive game for energy investors. The $60 WTI level that we are rapidly approaching as I write was the launching point for the spike in prices that occurred in 2007, as the chart below indicates, so may at least provide some support as the year ends. For investors who believe that could be the case, there is a good trade opportunity if that does turn out to be a good support level, but that also has the potential to pay off even if prices continue to fall.
As the cost of oil, and therefore energy sources in general have fallen, so the companies that convert that raw material into usable power, the utilities, have gained favor. It is one of the best performing sectors so far this year, as evidenced by the iShares Utility ETF (IDU), which is up close to 25% on the year.
It is not just falling oil prices that have fueled (forgive the pun) this out-performance by utilities.
Obviously, lower fuel costs are a benefit, but there are several other factors that have driven investors to the sector. First, the U.S. economy has continued to gain strength as the recovery has picked up pace. Output, and therefore demand for electricity continues to increase. In addition, the high yields associated with the industry have been attractive as interest rates have remained at historic lows and income investors have been reaching for yield. Dividend paying stocks were all the rage in 2013, but general stock market strength has made value there hard to find. That lack of value in stocks in general has also led to investors preferring sectors that had, until this year, lagged behind the general upswing in stocks. Utilities certainly fit that description.
These are all sound reasons for out-performance, but there are signs that all of them could be coming to an end early next year, making shorting IDU an attractive trade.
At least part of the reason for oil’s drop is the expectation of a slowdown in global economic growth in the near future. While the U.S. economy looks well placed to withstand that, if it is not too drastic, some knock-on effect is almost inevitable if it transpires. Utilities have done all of the catching up that they can do, and at these elevated levels any hint of a temporary reduction in U.S. economic activity will have an exaggerated effect on the stocks.
It is the status of utilities as a source of yield, however, that represents the biggest danger to IDU and other sector ETFs. The Fed has made it clear that they are actively looking for a time to begin the “normalization” of interest rates. If this Wall Street Journal article is to be believed, they are about to drop the now infamous phrase “considerable time” from their next policy statement, raising the specter of a rate hike around the middle of next year. Of course, any such rate rise will be only incremental, but once the illusion of a zero interest rate policy ad infinitum is gone markets will be anticipating further increases. A rising rate environment, or even the expectation of one, will put pressure on anything seen as a source of yield, not least the power companies.
Part of the appeal of this trade is that, should oil prices remain low or fall further, the boost that will give to economic activity would make earlier and sharper increases in interest rates, or at least the expectation of them, more likely. If oil recovers, then the benefit of lower costs will be short-lived. Either way, a sell off in utilities is on the cards.
There is, of course, always danger in a contrarian trade, so with strong momentum going in, this would be a trade to watch closely. Investors should be prepared to cut for a small loss if the upward trend continues, say at around 125, which would equate to a manageable potential loss of around 7 percent. If all of the factors in the Goldilocks scenario that has led to such strength in IDU fade early next year, however, a fairly rapid retracement is likely, and the 85 level from the start of the year looks attainable. That would represent a 27 percent profit target.
Oil prices may find some support at the $60 level for WTI, or they may not. Whether they do or not, though, shorting utilities after a strong year gives a decent chance of a profit.