Research Excerpts

When To Overweight Energy / Buy Oil?

Posted on: Thursday, December 4th, 2014

In our June 4th 2014 blog posting, entitled Oil Prices: Smart Money Skeptical At $103 Per Barrel, we republished a chart and some analysis from a recent premium report that showed commercial hedgers were holding a near record net short position in NYMEX crude oil futures.  We said that this represented an aggressive bet by the smart money in the oil business, companies that owned the cash commodity either in the barrel or in the ground, that oil prices were over-valued and due for a significant decline.

Crude oil prices subsequently peaked 3 weeks later, on June 25th, and have since declined by $33 per barrel or 34% into this week’s lows.

Before that, in January, our in-house model showed that just 10% of ETF-related sector bets were being allocated to the Energy Sector versus 20% historically, per the chart below.

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Chart 1: Data though 12-31-2013

This metric told us that the Energy Sector was severely under-invested and thus amid favorable conditions for an upcoming 1-2 quarter period of relative sector outperformance, as well as probable coincident strength in energy related assets like crude oil prices.  The big question, though, was “when?”. 

Trying to pick a bottom in a declining, under-loved asset is dangerous business because, if your timing is wrong, you can get run out of the trade before it ever has a chance to become profitable.  We addressed this obstacle with another in-house metric that indicated when investor assets actually started to move back into Energy, in lieu of other sectors.

The next chart, which plots the daily relative performance of the Energy Sector SPDR ETF (XLE) versus the S&P SPDR ETF (SPY) in the upper panel and the daily percentage of ETF sector bet-related assets allocated to Energy in the lower panel, between October 2013 and October 2014, shows that the day-to-day percentage of these assets started to expand back above their 63-day moving average in early March.  This indicated that a new quarterly trend of expansion was beginning.

Chart 2: Daily % Of Sector Bet Assets Allocated To Energy

Chart 2: Daily % Of Sector Bet Assets Allocated To Energy

This, along with other components in our model, moved it to to an overweight status in early March that allowed us to capture 11% of relative sector outperformance by late June.  Then, when the daily percentage of assets invested in Energy contracted back below their quarterly moving average in July — which corroborated the big bearish bet that the smart money commercial hedgers had made on oil prices earlier in the month per our June 4th blog postingour model exited the overweight in Energy and avoided the nasty trend of relative underperformance that followed.

The next chart, which is the current version of Chart 1 above updated through the end of last week, shows that the percentage of sector bet-related investor assets allocated to Energy has contracted back to just 11%, which puts it very close to the 10% extreme reached at the end of Q4 2013.  This suggests that another opportunity to overweight the sector and to buy crude oil may be emerging.

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Chart 3: Data through 11-28-2014

Once again, however, the key is to not be the first one in a new trade to overweight the Energy Sector because that is where all of the uncertainty and most of the risk is.  We’d rather let someone else be the pioneer and try to pick that bottom, while we wait for enough positive asset flow to come back into the sector to support and sustain an overweight position, and potentially to signal a bottom in related assets like oil prices.

The purpose of these blog postings are to display, discuss, and explain our approach to trading/investing in financial assets, which utilizes both quantitative and technical metrics to help professional investors manege risk and improve performance.  Our proprietary trend model for the S&P 500 has doubled the performance of SPX since 2007 while significantly avoiding drawdowns.

Asbury Research subscribers can get more data and analysis on the Energy Sector and oil prices via our recent premium report, entitled Crude Oil & The Energy Sector: Opportunity Or Liability?, by logging into the Research Center.

Interested investors can get subscription information by clicking here or by calling 888-960-0005.