One Way To Play A Pullback In Oil Prices

A couple of weeks ago, when the rumors started about the production cuts that OPEC+ confirmed yesterday, I wrote that, from a long-term perspective, the cuts didn’t alter my bearish view on oil. That view, I said, was based on economic data that suggested the US, maybe even the world, was entering into a period of stagflation. Well, OPEC+ not only confirmed the rumors of cuts, but set them at the upper end of expectations. After trading lower for a couple of days after I wrote that, oil bounced back strongly as those rumors gained legitimacy, and is higher now than it was then as a result. However, the economic data is, if anything, worse now than it was then, and with the Fed indicating more rate hikes to come and earnings that are generally anticipated to be disappointing getting underway next week, the rally doesn’t look sustainable.

So, while things haven’t worked out exactly as planned to this point, I have been looking for stocks that I think are vulnerable should oil, or stocks in general, head lower again over the next couple of weeks, as I expect both to do.

It seems to me that the answer lies in things that will be hit by a reduction in output, whether that comes on the supply side, from the cartel, or from a drop in demand as economic conditions worsen. Oilfield services stocks fit that bill and the one that stands out as a sell is Schlumberger (SLB), based on the fact that SLB has bounced back, their earnings aren’t due out until two weeks from now, on October 21^st, and I am looking to establish a short position that is in profit before then to allow me to run it through the announcement.

There is a generally positive feeling around oil stocks right now as the supply cuts have protected the sector from the declines in stocks seen elsewhere, but with oil having dropped 24.8% during Q3 and now with output cuts coming from OPEC+, there is a good chance that even if the Q3 numbers are decent the outlook from Schlumberger for Q4 will disappoint traders. Taking an advance position like this is always risky so it would normally make sense to wait for earnings, but there is a reason to get short now, rather than wait.

The above is a chart for SLB since June. The three blue lines represent the top and bottom of the drop that began on the 8^th of that month and ended just over a month later, with the middle line marking a 61.8% retracement of that move, a significant level in Fibonacci analysis. As you can see, the stock closed Thursday right around that level, so now looks like a good time to sell.

As always, I will be setting, and sticking to, a stop level for this. In this case, the most obvious level for a stop is the early June high, but that is around 20% from here. That is more than I want to risk on a trade where the initial target level would be a drop back to around $35, representing a targeted profit of around the same percentage. So, I am looking instead at the gap that formed over the June 10^th to 13^th weekend as a level to use. That means setting a stop at just over $46, about 10% from here, giving a 2:1 reward to risk ratio.

Of course, if you disagree with my view on oil, or on stocks, or both, this isn’t for you, nor is it a viable trade if you don’t have a margin account and aren’t able to short stocks. Even if that is the case, though, I wanted to lay out both the rationale and the methodology behind the trade here because it is an approach that you can use in other situations. Analyze the fundamentals, reach a conclusion, then look for something where there is a technical rationale for the position, as well as the fundamental. It is an approach I was taught forty years ago when I started in the markets, and it is as valuable today as it was then.