Oil is setting up to be a potentially powerful contrarian trade. Keep in mind that all contrarian trades are risky. But, with risk, comes reward. Oil is experiencing a high level of capitulation vs. other cyclical equity sectors like metals etc.
The bull case
Clearly, a Trump win in November would aid the oil sector, given his approvals surrounding pipelines and other projects. However, the energy sector also has upside with a Biden Presidency despite Biden’s anti-pipeline, pro “green” tendencies. According to Deloitte: Seven out of 10 US oil and gas jobs that have been lost because of this year’s oil crash will not be reinstated by the end of next year. Even with a Biden win, Washington will likely give the sector breathing room after this horrific year for the energy sector.
Larry McDonald of BearTraps recalls a Merrill Lynch contrarian indicator from decades ago: “A buy signal comes whenever there was a protracted bear market, the end of it was invariably announced by headlines of mass layoffs, the classic being the summer of 1982. The peak of layoffs in 1982 launched the meta-bull market we are still in to this very day. And now in energy, after years of disaster, we are seeing massive layoffs announced or being readied for announcement pre-year end.”
Larry feels that the fourth quarter of 2020 will be for oil what the summer of 1982 was for the brokerage industry, which brought on the Great Bull Market.
Let’s look at the sentimentrader oil optix, below. The optix combines sentimentraders various surveys of smart and dumb money, along with trading patterns to illustrate deeply bearish or bullish sentiment on a commodity or stock sector. I’ve circled the times since 2011 that oil got into the “too pessimistic” range, which is a contrarian buy signal. Its generally resulted in a rally. As you’ll note, the indicator isn’t there yet, but if you look closely at the chart, you will see its heading that its heading that way. So…crude oil isn’t a contrarian buy…. yet. But what about the energy stocks?
The sentiment picture changes a bit for the producers, who are the guys seeing these layoffs noted by Deloitte, above. Investors are throwing energy stocks down the drain. The optix below, again courtesy of sentimentrader, tends to give contrarian buy signals after prolonged periods (clusters) of bearish sentiment. That’s what we are seeing now – a cluster of bearish sentiment. It could last a little longer, but the longer that sentiment is bearish, the greater the case for a rebound. Keep in mind Larry’s observations noted above of the 4th quarter of this year being a possible capitulation buy point.
The technical view
The chart below presents a scary picture – just in time for Halloween! XLE is the well-followed large capped oil producer ETF traded in the USA. I’m going to watch for a capitulation buy signal on an RSI hook and – even better – a more positive MACD movement. That’s not here yet. Things are getting oversold, but not yet completely washing out. Again, this might add evidence to Larry’s 4th quarter capitulation opportunity comments. keep in mind that if we do see a bullish chart, we will want to focus on the big producers. The opportunities in a depressed sector arise from the strong swallowing the weak via mergers and buyouts.
Energy Bear Case
According to EquityClock’s chart, the case for buying crude oil is not great between now and late February. So, there’s that. But seasonals seem to be taking a back seat to politics when it comes to investing lately. So, lets take a look at the presidential policies – already covered to some extent in the bullish case noted at the top of this blog. But there is a bearish item that investors need to keep in mind for energy…
Biden has explicitly said that he will reinstate the Iran nuclear deal. With the lifting of sanctions in oil (recall that Iran has been unable to sell their usual quota of oil due to their violation in the nuclear deal) comes more supply, specifically from a large producer (Iran) that badly needs economic relief. This is the argument by the bears who believe the next big trade for the barrel is a fall back into the $20 area….
Again to quote Larry McDonald as a counter-argument: This (addition of Iranian oil to the market) is a good point, although we do not think Iran supply could get online fast enough to push oil down that low, assuming inflationary pressures elsewhere.
Energy is not going to be an obvious trade. Its got risk, to be sure. However, like some of the other contrarian plays out there (airlines, hospitality & tourism), there’s always the chance for massive bailouts, or other events that could bullishly catapult a sector that is so deeply out of favor. I think the energy sector, along with a few others, are worthy of watching for technical signals and a fundamental catalyst that might back a sustained move. Keep an eye open for such opportunities. The time to buy is when the blood is running in the streets, as Rothschild once said.