Crude’s Correlation to Stocks is Breaking Down, and That Creates Some Opportunities in Energy

By Martin Tillier

Last week, I emphasized the fact that sometimes, no position is the right position. There were several reasons why I couldn’t see a clear direction for oil, and therefore most energy stocks, but one of the things that held me back was that WTI futures had been tracking U.S. equities for a while. As a result, any analysis of the oil market could be spot on, but in the short term you could still see a big move against your view based on something outside of oil.

Stocks outside the energy sector are, in many cases, back to or even above their pre-shutdown levels, even though the economy is still reeling, and there are still significant risks. That leaves the market vulnerable to a sudden reaction to even slightly bad news, and as long as stocks and oil are correlated, oil would also fall dramatically in that scenario, even though its recovery has been more measured.

That correlation, however, looks to have broken this morning. As of mid-afternoon, the Dow was around 70 points lower than yesterday’s close, while both Brent and WTI were showing gains of around 2% on the day.

Admittedly, neither of those are anything to write home about given the volatility we have seen recently, but even so, oil and stocks moving in opposite directions is rare enough these days to be noteworthy. More importantly, it makes establishing positions based on higher crude less risky than it was last week because it means that the supply factors that can drive crude higher are coming to the fore.

Why the Rally Stalled

With oil, as with any commodity, changes to supply conditions usually take longer to implement than shifts in the demand profile. When the U.S. economy shut down a few months ago, demand for gasoline, and therefore crude, was decimated almost immediately.

Supply, on the other hand, fell relatively slowly, reducing by only around 20% from the end of February until the beginning of June.

Shuttering a productive well is a big decision, and given the inherent volatility in oil, a lot of companies chose initially to keep pumping and hope for a recovery. We saw the effects of that towards the end of April, when the expiring front end futures contract dropped so spectacularly into negative territory.

At around that time, OPEC+ reached an agreement to cut production, and the experience also accelerated closings in North America.

By then, some U.S. states were taking the first steps towards re-opening, as were several major industrialized nations. Coming from near zero, demand rose quickly, and price with it. There was, however, still a significant glut of oil to get through, so the rally stalled at around $40/barrel.

What Next?

Now though, crude storage, both in tankers offshore and at key hubs such as Cushing, has returned to something like normal levels.

With supply still falling and demand increasing, the way is clear for WTI to break through that $40 level. The last two tries have failed, retreating rapidly from a high of $40.44 on June 8th, then falling short at 39.91 a couple of days later. That led to a drop to $34.50, but the formation of a double bottom there gives the chart a bullish look.

What Are the Risk Factors?

On the negative side, the most obvious risk is the one we hear so much about in equities… a second wave of Covid-19. That is a real possibility, so if there is any sign of states reversing their relaxation of stay-at-home rules, all bets are off.

On the supply side, there is also the risk that cash-strapped E&P firms will try to ramp output back up quickly, although the big cuts to capex and the still accelerating declines in output make that look unlikely to happen soon.

Conclusions

As the bard once said, one swallow doth not a summer make, but a small, corrective move down in stocks at the same time as a decent rise in oil does give me hope that WTI can begin to catch up with U.S. stocks. On that basis, I will be nibbling at some larger and medium-sized E&P stocks over the next couple of days.

Companies like Occidental (OXY) and Concho Resources (CXO) could see their stock make significant gains over the next few weeks if current supply and demand trends continue and crude does break above $40.

As I said, there are still some significant risks, but with value elsewhere in the stock market becoming increasingly rare, there is a good chance that energy will outperform for a while.

Good Luck!

Cheers,

M

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