Energy stocks versus crude oil prices
In the first half of 2014, energy stocks were rising faster than crude oil spot prices. Both stocks and commodities peaked in the summer, then began declining through the second half of the year.
So far, crude oil has experienced a 58% decline since the summer highs, and continues its downward trajectory. West Texas Intermediate briefly touched the $44 mark on January 13th and is currently sitting near 5-year lows.
However, US energy stocks have faired considerably better. Energy stocks bottomed in mid-December, falling 27% from the summer highs. But stocks have since rebounded and are now only 23% lower than their all-time highs.
So why the big divergence? Stocks tend to lead the underlying commodity, trading on forward expectations. Rising energy stocks are therefore signalling that traders expect the price of oil to recover and won't go much lower from here. Politicians, energy executives and CEOs have all echoed the sentiment that West Texas will average $60 per barrel in 2015, requiring a significant bounce from the current $45 price. Investors have drunk the Kool-Aid and are buying into energy stocks in anticipation of a reversal in the price of crude.
Although no one really knows if the price of crude oil has truly bottomed, consider the facts:
- Crude oil supply is expected to continue increasing through 2015. Countries such as Russia and Iran are increasing production in an effort to offset lower prices. Production in US and Canada is also expected to rise this year, albeit not as fast as originally projected. So far, no one has stepped up to the plate and offered significant production cuts. The glut in crude supply is therefore not expected to subside any time soon.
- As noted last week, the price of all commodities is falling along with crude oil, signalling global economic weakness and insufficient demand. In the past 10 years, commodity prices have been largely driven by strong demand in Asia, which is not expected to rebound any time soon.
- The US dollar continues to strengthen against all other currencies, particularly the Yen and the Euro, which are actively being devalued by their respective central banks. A strengthening US dollar is bearish for crude oil and all commodities in general.
So why is this important? If traders are wrong and crude oil prices do indeed keep falling, expect a fast and sharp decline in energy stocks. Seasoned investors never bet against the trend, and the trend in crude oil is clearly down. It would be safer to wait for a meaningful reversal or stabilization in the price of crude before plowing back into energy stocks.