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Oil Stocks Deeply Oversold

Adam Hamilton
http://www.zealllc.com/essays.htm
June 11th, 2010

Oil stocks have been hammered especially hard in the recent stock-market correction. With both the general stock markets and price of crude oil falling sharply, the oil stocks didn't stand a chance. The result of all this carnage is deeply-oversold oil stocks, a fantastic buying opportunity for speculators and investors.

Oil stocks, of course, are in the business of exploring for and producing crude oil. Thus it is not surprising that the price of oil is one of their primary drivers. Higher oil prices make oil more profitable to produce, and the greater an oil company's profits the higher its stock price will be bid. So oil-stock traders naturally watch the price of oil closely. But provocatively oil shares its primary-driver role.

This sector's other primary driver is the general stock markets. When the S&P 500 (SPX) is rallying, oil stocks climb in sympathy even if oil happens to be flat. When the SPX falls sharply, oil stocks follow it lower even if oil is rallying. So like most commodities-stock sectors, the fate of the oil stocks is inexorably intertwined with the ongoing fortunes of the general stock markets.

A couple years ago I did a study on the relative influence of oil and the SPX on oil stocks. Both had nearly identical correlation r-squares (nearly 90%) with the flagship XOI oil-stock index between 2003 and early 2008. Sometimes oil was more important, and sometimes the SPX was. But the oil stocks' performance was the best when both these primary drivers were rising and the worst when both were falling. And often oil prices moved with the SPX as stock-market fortunes influenced commodities traders, something we've seen recently as well.

Since April, both crude oil and the general stock markets have suffered through the largest corrections of their cyclical bulls. Seeing both of oil stocks' primary drivers down hard simultaneously had a devastating impact on oil stocks. Widespread fears, most of which were pretty irrational, drove oil stocks down to unbelievable lows. If you want to buy low, fear is your friend. This week it drove the best oil-stock buying op that we've seen in at least a year.

To understand how deeply oversold oil stocks became this week, you have to understand the technical context. I've included cyclical-bull charts for oil and the oil stocks, which are quite compelling. A third chart, the SPX cyclical bull, is also very important for oil stocks. But I discussed that last week in another essay on the general commodities-stock buying op, so here I'll just reference last week's SPX chart.

We have to start with oil, which has just weathered the biggest correction of its entire cyclical bull. In addition to the usual oil technicals, this chart also shows oil relative to its 200-day moving average in light red. This important metric from my simple yet powerful Relativity trading system helps traders identify and capitalize on excessively overbought and oversold conditions in real-time.

Like everything else during the infamous stock panic, oil was driven to irrational deeply-oversold levels in late 2008 and early 2009. But since then, it has skyrocketed 152% higher at best in a powerful cyclical bull. This performance is stupendously good, reflecting how silly the low oil prices were in early 2009. For reference, over a similar timespan the flagship SPX stock index only rallied 80%. Oil has been a rockstar!

Like all bull markets, oil periodically experienced sharp corrections along the way. These are healthy and normal events that rebalance sentiment, keeping greed from getting too excessive before a bull climaxes. Prior to our latest correction, the first 4 oil corrections averaged 15.4% over 24 trading days. And as you can see above, these corrections were all very similar in magnitude with no major outliers.

Despite these sharp corrections from time to time, oil continued to power higher on balance in a strong uptrend. By early April 2010, it was approaching $87. This was a far cry from the ridiculous $34 levels it had briefly languished at just 14 months earlier. After topping, oil consolidated high in mid-April averaging $85 on close over the subsequent 3 weeks until the SPX topped on April 23rd.

At that point, the US stock markets started pulling back. And as is usually the case, retreating stock markets spawn endless worries about the economy. When oil-futures traders see weak stock markets, they assume the global economy must be weakening too and therefore near-future oil demand won't be as strong. So oil tends to get sold in sympathy with major SPX retreats.

If you compare the oil chart above to last week's SPX chart, the temporal correlation between oil corrections and SPX pullbacks and corrections is dead on. Since last summer, the big oil corrections noted above have usually coincided with major SPX retreats. In addition, weak stock markets drive flight capital into the US dollar and Treasuries. Since oil is denominated in US dollars, dollar rallies drive global oil prices lower. Thus SPX retreats hit oil on two fronts, the economic-sentiment one and also the stronger-dollar one.

The net result of the biggest SPX correction of its cyclical bull and the strong dollar rally since late April was the sharply-lower oil prices we've just seen in oil's 5th major correction. This all-important flagship commodity plunged 20.0% lower over 36 trading days ending in late May! In addition to being about a third bigger and half-again longer than the average of the previous 4 corrections, this latest one drove oil below its uptrend's support and 200dma to deeply-oversold levels.

Oversoldness is measured from a gradually-changing baseline, and the 200dma is the perfect one. Relative to its 200dma, oil fell to its lowest levels in 12 months. Between 2005 and 2008 prior to the stock panic, we used a relative trading range for oil of 0.98x to 1.25x. Under 0.98x was very oversold, the time to go long. And when oil surged over 1.25x its 200dma it was very overbought, the time to close longs and add shorts. By late May in this latest correction, oil plunged under 0.91x its 200dma! With the exception of the wild stock-panic span, oil hadn't been this oversold since early 2007 when it traded in the $50s.

While oil's correction matches the SPX's own perfectly, another important psychological event happened right before it began in earnest. On April 20th, Transocean's Deepwater Horizon drilling rig exploded in the Gulf of Mexico. A couple days later, it sank in 5000 feet of water. Of course the tragic wellhead blowout that doomed this rig also led to the catastrophic oil spill in the Gulf that is saddening the world today. Much of oil's correction coincides with this growing oil spill, so some analysts claim the two are related.

Fundamentally though, this doesn't make any sense. The horrible economic impact of this massive oil spill has understandably fanned anti-drilling sentiment to previously-unimaginable heights. This oil spill will make drilling much harder and more expensive in the future as oil companies are forced to jump through endless new hoops. Any event that reduces future supply is fundamentally bullish, not bearish.

Even if this tragic oil spill had never happened, oil still would have experienced its largest correction of this bull because the SPX was weathering the largest correction of its own bull and the US dollar was soaring. If anything, the Gulf oil spill's psychological impact on future drilling probably retarded oil's latest correction a bit.

With both oil and the SPX down sharply in their biggest corrections of their bulls, the oil stocks were doomed to spiral lower. And they certainly did! This next chart looks at the XOI oil-stock index, which has just fallen off a cliff. While very painful for existing oil-stock investors, this massive decline has driven the best buying opportunities we've seen in oil stocks since at least last summer. They are deeply oversold.

As oil stocks didn't fall as low as oil during the stock panic, they didn't rebound as far as oil after it passed. The XOI is only up 48% at best in its cyclical bull to date, well underperforming oil's 152% and the SPX's 80%. This is certainly disappointing, but it is largely explained by the gigantic oil stocks that dominate the XOI. Not only do they typically trade at lower valuations than the broader markets, but their market capitalizations are so enormous that their stocks are slow to move. Kind of like oil supertankers.

The XOI's major retreats prior to this latest correction mirror oil's exactly, and of course most of oil's mirror the SPX's. But the XOI has been more volatile than either of its primary drivers. Running between 7% to 16%, the standard deviation of the XOI's pullbacks and corrections was much wider. The first 4 prior to today's averaged 11.1% over 26 trading days. This helps show how crazy the XOI's latest correction has been.

Between April 23rd, the very day the SPX topped but 3 weeks after oil did, and this Wednesday the XOI plunged 22.0%! As you can see in the chart, this correction was gigantic. It doubled the preceding bull-to-date average over a period of time about a quarter longer! The result was a shattering of the XOI's consolidation support line and deeply-oversold levels approaching a 14-month relative low. Oil stocks were just taken out behind the barn and shot, practically abandoned.

The elite oil companies are so enormous that the impact of a 22% loss in the XOI is staggering. At the end of April, the 13 XOI component companies had a collective market capitalization of $1232b. Meanwhile the entire Dow 30 sported a market cap of $3638b, or $3154b if you remove its two giant oil-stock components (XOM and CVX) that are also in the XOI. So the XOI oil companies alone were almost 40% of the size of all 28 non-oil Dow 30 components!

This implies a total loss of elite-oil-stock market capitalization in this correction approaching $267b! A 22% correction in the major oil stocks is a huge deal! Of course the catastrophic plunge in the former British Petroleum exacerbated the overall XOI decline. In late April, BP alone represented around 13% of the entire market cap of the XOI oil-stock index. Peak to trough since the Deepwater Horizon explosion, BP's stock has lost a staggering 52% of its value. This translates into around $90b in market-cap terms.

So without BP stock's death spiral, the XOI's recent correction would have been milder. But not dramatically so. As BP's stock was gradually cut in half as the toxic crude continued deluging forth from its deep gusher, its influence in the XOI waned. At worst, with a 1/8th weighting and 50% plunge, it accounted for about 6% of the XOI's 22% correction. But the reality is probably more along the lines of 3% to 4% thanks to its declining weighting. So even ex-BP, the XOI's recent correction was very large.

The oil-spill psychology certainly had a major impact on this steep oil-stock decline. The endless oil-spill images and coverage is making everyone feel sad and helpless. Though this was the first disaster after over 600 deepwater wells (a water depth beyond 500 feet) drilled in the Gulf of Mexico, it has vilified the entire oil-stock sector in the minds of pandering politicians and dimwitted Americans. One blowout at one well owned by one company has tarred this entire sector with a brush of loathing.

But while this spill is terrible and catastrophic and tragic, the world economy marches on. The world is still consuming crude oil at far-faster rates than new reserves are being discovered and brought online. With this kind of supply-demand imbalance coupled with half the world's population in Asia rapidly ramping up its per-capita energy consumption, higher oil prices for years or even decades to come are inevitable. The only source for this oil is the oil companies, all of which except BP had nothing to do with this spill.

The Marxists running Washington are making this situation even worse for American consumers and more bullish for oil prices. Now they consider a 1-in-600 catastrophic failure a high-probability event and have banned deepwater drilling. This kneejerk reaction is driving drilling rigs to other countries. Oil companies need to make reservations to lease these rigs years in advance. So American oil production in the Gulf is going to be lower for years to come thanks to the Obama Administration's irresponsible grandstanding. This virtually guarantees higher gasoline prices for American voters for years to come.

Higher oil prices, whether driven by Chinese and Indian consumers or knucklehead American politicians, are great for oil stocks. So this deeply-oversold buying opportunity created by the combination of a large oil correction, a large SPX correction, and oil-spill psychology should be seized by prudent speculators and investors. Many smaller oil producers actually fell much farther than the giant majors of the XOI. The small oil-stock bargains are the best we've seen since the stock panic in many cases!

At Zeal we've been aggressively buying oil stocks in recent weeks as the XOI plunged. Most of these purchases were made in our popular weekly Zeal Speculator newsletter. We're sifting through the carnage to find smaller high-potential oil producers drilling and pumping in promising oilfields here in the States and abroad. These small oil stocks should easily double over the next year as oil and the SPX recover, and it wouldn't surprise me to see them triple or quadruple. Today's opportunities are amazing.

A lot of investors are confused and confounded by the volatile stock markets, but you don't need to be. My life's work is studying the markets, understanding what is driving them and why, and capitalizing on these trends with high-probability-for-success trades. You can share in the fruits of my research company's labors and greatly deepen your knowledge of markets and investing. In this realm, knowledge is power that short-circuits destructive greed and fear and leads to multiplying wealth. Subscribe today to our acclaimed monthly Zeal Intelligence newsletter and start capitalizing on the endless opportunities!

The bottom line is oil stocks are deeply oversold today. A sharp general-stock-market correction spawned the pessimistic economic psychology that led to a concurrent sharp oil correction. As always when both of their primary drivers are falling fast, oil stocks got hammered. But this time was even worse due to the flood of negative emotions the terrible oil spill has understandably unleashed. Oil stocks were sold with reckless abandon, leading to some of the best bargains since the stock panic in some cases.

But while the irrational oil-stock fear we've seen in recent weeks will soon pass, the global need for crude oil will not. As always after oil-stock corrections, this sector will be bid back up almost as fast as it fell. Contrarian speculators and investors willing to fight the crowd and buy today's bargains before mainstreamers catch on will be richly rewarded. Oil stocks are deeply oversold, and such emotionally-driven conditions never last.

Adam Hamilton, CPA

June 11th, 2010

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