Energy Stocks Have Been Down For So Long

by Cam Hui, Humble Student of the Markets

The recent incidence of a cold snap in North America brings up memories of the polar vortex of last winter (via Bloomberg, emphasis added):

Remember how evidence was mounting last month that early snowfall was accumulating across Siberia? And remember how there’s a theory that says this snowfall signals a cold winter?

So in the two and a half weeks since, the news for the winter-haters has, unfortunately, only gotten worse.

About 14.1 million square kilometers of snow blanketed Siberia at the end of October, the second most in records going back to 1967, according to Rutgers University’s Global Snow Lab. The record was in 1976, which broke a streak of mild winters in the eastern U.S. In addition, the speed at which snow has covered the region is the fastest since at least 1998.

Taken together they signal greater chances for frigid air to spill out of the Arctic into more temperate regions of North America, Europe and Asia, said Judah Cohen, director of seasonal forecasting at Atmospheric and Environmental Research in Lexington, Massachusetts, who developed the theory linking Siberian snow with winter weather.

“A rapid advance of Eurasian snow cover during the month of October favors that the upcoming winter will be cold across the Northern Hemisphere,” Cohen said in an interview yesterday. “This past October the signal was quite robust.”

Natural gas prices have spiked in response to the cold weather, though they have pulled back in the last few sessions.

As well, energy stocks have begun to rally relative to the market. Could the possible onset of another polar vortex this winter present an opportunity to buy this sector?

No supply cutbacks = Further price pressure
While there may be a brief tradeable bottom in energy stocks here, I wouldn't get overly excited longer term on this sector just yet. Platts reported on their blog that companies remained upbeat during their latest earnings calls (emphasis added):

If you listened to third-quarter earnings calls of US upstream operators these last few weeks, you couldn’t help but be struck by the positive note that was sounded during them.

On the one hand, the bogey of lower oil prices hunched in the background like one of those evil Disney characters with wretched hairdos, pointy noses and crooked teeth, muttering, “I’ll get you, my pretty.” But on the other hand, oil executives were talking about double-digit production increases despite potential activity trims that could result from a prolonged WTI oil price environment below $80/barrel.

Almost to a CEO, managers said they believed they could operate at that price level, at least for awhile, without too much in the way of consequences. Moreover, they didn’t panic. And they appeared sanguine about their ability to grow production next year, especially oil production, often by double digits.

Instead, they emphasized their flexibility, strong balance sheets and intention to focus on their highest-return projects, and said they were prepared to cut back on or temporarily shelve marginal drilling.

Translation: Don't expect a supply response from energy producers. These comments more or less guarantees further downward price pressure on energy prices.

Don`t get overheated on cold weather
In addition, not everyone agrees on the prospect for a cold winter. The latest NOAA outlook states:

THE TEMPERATURE OUTLOOK FOR NOVEMBER-DECEMBER-JANUARY (NDJ) 2014-15 INDICATES ELEVATED PROBABILITIES OF ABOVE-NORMAL MEAN TEMPERATURES FOR ALASKA, THE FAR WEST, ALONG THE NORTHERN TIER OF THE CONTINENTAL U.S. EASTWARD TO INCLUDE PARTS OF THE NORTHEAST AND MID-ATLANTIC. BELOW-NORMAL MEAN TEMPERATURES ARE MOST LIKELY OVER AREAS FROM EASTERN NEW MEXICO TO THE WESTERN GULF COAST STATES.

The NOAA 6-10 day forecast does call for continued cold temperatures, which could be supportive of short-run natural gas demand.

By contrast, here the one-month outlook calls for a warmer winter:

The three-month outlook is calling for colder temperatures in the US South, but warmer elsewhere.

In short, don`t count on the weather to heat up energy stocks.

Possible tradeable rally, but still in downtrend
For the last word, consider this 10-year chart on the relative performance of energy stocks vs. the SPX. This sector has been rolling over on a relative basis since 2008. They are now at the bottom of a relative downtrend channel and appear oversold and could be setting up for a counter-trend rally. In addition, energy stocks getting cheap on valuation metrics and they are likely to attract attention from value investors (see Do you have what it takes to be a contrarian investor?)

My inner trader believes that energy stocks could be setting itself up for a tradeable rally. My inner investor remains cautious on the sector given the headwinds posed by a strong US Dollar, which negatively affects commodity prices, and the lack of a supply response from producers.

Copyright © by Cam Hui, Humble Student of the Markets