Monday will mark the start of earnings season, the three week period during which the majority of S&P 500 companies report revenue and EPS for the previous calendar quarter. Over the last eighteen months or so that has been a scary time for energy investors as the extent of the pain felt by many companies as the result of the oil price collapse became clear. Once again, much of the focus over the next few weeks will be on the energy sector, and expectations seem to be for more of the same. Those very expectations, though, may provide a clue as to why it might not turn out to be too bad.
In dealing rooms around the world, traders are taught to anticipate and assess what others are doing. When it seems that everybody feels the same way about something you first go with the momentum. After all, if everybody is buying the price will go up. At some point, though, it pays to take a contrarian view. Once everybody is long profits will be taken, and even a relatively small amount of selling into a market that is generally long will quickly reverse that momentum. The same is true in the opposite direction; when a lot of people are short, or at least have held off of buying, any move up will quickly become exaggerated.
After a year and a half of tumbling prices in the energy sector, and with analysts seemingly competing to publish the most negative estimates, it could well be that energy stocks have reached that point. If nothing else it makes it unlikely that bad news…
Monday will mark the start of earnings season, the three week period during which the majority of S&P 500 companies report revenue and EPS for the previous calendar quarter. Over the last eighteen months or so that has been a scary time for energy investors as the extent of the pain felt by many companies as the result of the oil price collapse became clear. Once again, much of the focus over the next few weeks will be on the energy sector, and expectations seem to be for more of the same. Those very expectations, though, may provide a clue as to why it might not turn out to be too bad.
In dealing rooms around the world, traders are taught to anticipate and assess what others are doing. When it seems that everybody feels the same way about something you first go with the momentum. After all, if everybody is buying the price will go up. At some point, though, it pays to take a contrarian view. Once everybody is long profits will be taken, and even a relatively small amount of selling into a market that is generally long will quickly reverse that momentum. The same is true in the opposite direction; when a lot of people are short, or at least have held off of buying, any move up will quickly become exaggerated.
After a year and a half of tumbling prices in the energy sector, and with analysts seemingly competing to publish the most negative estimates, it could well be that energy stocks have reached that point. If nothing else it makes it unlikely that bad news will precipitate another major drop. Factset, in their invaluable Earnings Insight, calculate that downward revisions of analysts’ expectations going into this earnings season are at their highest since Q1 2009, with energy being the worst sector. That sounds scary until you realize that the first quarter of 2009 actually marked the low point in the S&P 500.
There is evidence that, just as then, analysts have gone a little too far in their pessimism, particularly when it comes to energy. Both oil and natural gas prices were of course significantly lower over the last three months than in the same quarter last year, around 33 percent lower in both cases. Logically enough then, earnings estimates for this quarter are also lower, but, again according to Factset, they are lower by over 100 percent.
There are reasons why that obvious discrepancy is not as crazy as it first seems. Firstly, since the beginning of 2015 almost every energy company has cut back in some way, either shuttering wells or delaying the opening of new ones, so it is not a like for like comparison. In addition, profitability last year was still impacted by the fact that many companies had hedged future production at significantly higher prices.
Even given that, though, it looks as if the estimates are overly negative. That is only natural in some ways; analysts, like most people, have a “once bitten” attitude to their work and have been caught out by worse than expected results for about a year now. The tendency to be overly cautious in that situation is understandable, but it can lead to serious distortions. Even those draconian cuts by energy companies are, to some extent, a double edged sword. Yes, they will impact revenue negatively, but cost control will help the bottom line somewhat.
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I am not saying that energy sector earnings this quarter will be fantastic, only a fool would do so, but there is a good chance that stocks in the sector could benefit from a “not as bad as it might have been” rally. That is usually a bad reason to buy stocks from a long term perspective, but it does allow for an interesting trade.
Buying something like the SPDR Energy Sector ETF (XLE) and holding through the next few weeks of earnings releases makes sense. For sure there will be some who miss even the lowered expectations, announce further cuts, or reduce dividends, and that will have a negative impact on those stocks. Taken as a whole, though, the sector will not have to do much to exceed current expectations, and such a broad based play could well benefit if that is the case.
