Why This Earnings Season Could Be Difficult For Traders

Next week will be one of the busiest for Q2 earnings releases from S&P 500 companies in general, but it is also loaded with reports from the energy sector. Exxon Mobil (XOM), Conoco Phillips (COP), Anadarko (APC), BP (BP), and Total (TOT), to name a few, will be reporting on their performance for the second calendar quarter. Energy investors have become accustomed to wincing their way through earnings season, as one company after another announces a miss and, even more impactful on their stock, downgrades forward guidance. This time, however, could be different.

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The reason is fairly obvious if you take just a glance at the chart above. Oil prices hit their bottom at the end of February this year at $26.05, and for almost all of the first quarter WTI was trading below $40. The second quarter of this year, however, is virtually a mirror image of the first. WTI only once, at the start of the period, fell below $40 for a few days and peaked in June at $51.67. It doesn't take a genius to know that higher oil in the second quarter should equate to higher profits in the sector.

Of course, because that is not a hard thing to work out it would be reasonable to assume that the improved performance for the quarter is already priced in, and the chart for the large integrated firms such as XOM would seem to confirm that. XOM is up around 15% since the end of Q1. There are however, grounds to believe that even that, the best large cap performer in the sector over the last few months, could have further to go on the earnings release.

First, the initial reaction to earnings is always about how things stack up to expectations, or, to put it another way, how accurate Wall Street's guesses were. Considering that they are peering into the future, the analysts on average do a pretty good job with their guessing, but if they err, it is clearly on one side. For the S&P 500, around 67% of firms beat their estimates and have done so in every quarter for the last seven years. In fact, if you take the quarters in the recession out of the equation, that goes back decades.

So, if the natural, and to some extent expected, behavior is to underestimate earnings, imagine how strong that urge is in a sector that has pretty consistently kicked you in the teeth over the last four quarters. I know a few analysts quite well and I asked one of my friends, none of whom cover energy, what her attitude would be this quarter if she was in the sector. Her reply was "Recovery be damned, I'm not getting caught overestimating again!" Now, as much as that is anecdotal evidence, it conforms to what history tells us about the mindset of analysts.

The problem that I have, though, is that, with oil seemingly headed lower in the short term and the stock market looking nervous at new highs it is hard to take longer term positions in oil companies at these levels. As I made clear last week I am not a big fan of trading through major data releases, as risk control in those situations is extremely hard, but I may make an exception in one or two of these cases next week. Small intraday positions going into the releases, but still with realistic stops, will be my strategy, and if my suspicions about earnings are correct that could pay decent dividends.