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Oil Stocks Room to Run

Adam Hamilton
March 10th, 2012

With Iran waxing belligerent again, oil has been making headlines lately. Stock speculators and investors are anxiously watching its price, gaming how oil stocks are likely to react to various oil-price scenarios. And since the oil complex has already enjoyed a strong upleg, plenty of topping fears exist. But the technicals of oil and the leading oil-stock index, as well as their ratio, show lots of room to run higher yet.

Like everything else, oil and oil stocks were hit hard during the sharp stock-market correction last August and September. Between its late-April high and early-October low, the flagship S&P 500 stock index (SPX) fell 19.4%. Over this same span, oil plunged 32.4% while the benchmark XOI oil-stock index lost 29.1%. Both this commodity and the companies producing it leveraged the SPX losses, which is typical.

Straddling those early-October lows when traders had irrationally convinced themselves that the sky was falling, I was very bullish on oil stocks. With oil falling under $77 and the XOI to 995 on the day the SPX bottomed, the bargains in oil stocks were amazing. I wrote essays in late September and mid-October detailing the fantastic contrarian buying opportunities in the wildly-oversold and unloved oil stocks.

And indeed they soon started rallying. Between our two newsletters, we had deployed 10 oil-stock trades before and during the recent correction’s extreme weakness. At the XOI’s latest interim high on March 1st, their average unrealized gain was nearing 32%. Our eleventh trade was bought out in October at a 44% realized gain. With all these profitable oil-stock trades still on our books, should we be realizing gains?

I don’t think so. The biggest driver of oil and oil stocks by far is the fortunes of the general stock markets. The SPX’s overpowering sentiment bleeds into everything else, thus rising stock markets make traders optimistic about the global economy so they bid up oil and the oil stocks. And as I detailed in an essay on the SPX a month ago, today’s stock-market upleg still has plenty of room to run higher yet.

Provocatively the technicals in oil itself as well as the XOI oil-stock index look very similar to the SPX’s own. The current uplegs in both the commodity and its producers’ stocks remain immature with lots of headroom left. So as these charts show, there is no reason to fear a correction in either oil or the XOI yet. And oil stocks’ greatest gains usually accrue quickly in an upleg’s final couple months, when greed flares brightly.

This first chart looks at crude oil superimposed over a technical indicator called Relative Crude Oil. This rOil construct is based on my super-profitable Relativity trading system. It looks at prices as multiples of their own baseline 200-day moving averages. Over time they form horizontal trading ranges that reveal in real-time whether a price is too overbought (the time to sell high) or too oversold (the time to buy low).

First of all, oil’s mighty cyclical bull since its brutal secondary stock-panic lows in early 2009 has mirrored the general stock markets’ cyclical bull. Like the SPX, oil has seen two major uplegs and two major corrections before today’s in-progress third major upleg. Oil has generally marched higher within a well-defined bull uptrend rendered above. There is zero doubt that oil remains in a strong bull market.

Sometimes oil launches above or slumps below this uptrend, but only for a matter of months at most. Late in uplegs when euphoria reigns it can launch above resistance for a spell, and late in corrections excessive fear can temporarily break it below support. But for the most part, this uptrend has held solid. And with oil again above resistance today, some traders are understandably getting nervous.

But there’s no need to be, as this upleg isn’t mature yet. Last spring as oil’s second major upleg approached its climax, ballooning greed drove a major surge well above oil’s uptrend resistance. This upside breakout actually persisted for the better part of several months. Today’s young breakout in oil’s third upleg hasn’t even lasted a single month, this upleg hasn’t had time to climax yet.

As oil’s second upleg was peaking last April, this commodity became very overbought. The rOil metric climbed as high as 1.318x, meaning oil was stretched nearly 32% above its 200dma. The best we’ve seen recently is merely half of those topping levels, late February’s 1.161x. With oil not overbought, there isn’t yet enough greed and euphoria to suck in all near-term buyers and trigger a major topping.

We compute these Relativity trading ranges with the latest 5 calendar years of data. And rOil’s trading range based on this is now 0.90x on the low side (oversold) to 1.30x on the high side (overbought). With rOil only about halfway up into this range near its recent highs, it is nowhere near upleg-ending extremes yet. When rOil eventually challenges 1.30x in the coming months, which is likely, that is when to worry.

Also consider the progress in today’s third major upleg compared to how oil performed in this bull’s first two. At its latest interim high a couple weeks ago, oil had rallied 42.8% over 4.7 months. This is well below upleg two’s +63.9% over a much-longer 11.1-month timeframe. And this bull’s first upleg, though excessively large emerging out of the stock panic, ran 151.7% higher over 13.7 months.

The 42.8% we’ve seen so far is too little for a major cyclical-bull upleg, and oil has merely been rallying for well less than half the time of a typical upleg so far. The run we’ve seen until now is simply too minor to be classified as major! In addition, this upleg hasn’t pushed oil to any new cyclical-bull highs yet. Major uplegs in ongoing bull markets almost always carry their price well into new-high territory before failing.

And there’s no reason not to expect today’s oil upleg to be large. Why? Last autumn’s second correction of this bull leading into the current upleg saw oil fall to crazy-oversold levels. As you can see above, in rOil terms this commodity had not been anywhere close to as oversold since just after emerging out of the brutal secondary stock-panic lows in spring 2009! In general the more oversold a price is at an upleg’s birth, the higher and longer that upleg ultimately runs to catapult sentiment to the opposite extreme.

So with oil not yet overbought, not yet running high enough, and not yet rallying long enough by bull-to-date major-upleg standards, there is no reason to fear today’s upleg is rolling over. We need to see it extend for at least a couple more months, hitting major new cyclical-bull highs and pushing oil near 1.30x-its-200dma overbought territory, before it is time to start realizing profits and prepare for its third correction.

Not surprisingly since the price of oil ultimately drives their profits, oil stocks have exhibited a similar cyclical-bull pattern to oil. As measured by the benchmark XOI index (large-cap oil stocks), this sector has also seen two major uplegs and two major corrections. And the third major upleg underway today is in a similar state as oil’s, still much too immature to start worrying about an imminent topping in oil stocks

The same young-upleg arguments for oil apply to the XOI as well. Its Relativity trading range is 0.85x to 1.20x its 200dma. And the best we saw at its recent interim high in early March was just 1.102x, roughly only halfway to overbought territory so far. Before the XOI’s second major upleg peaked last April, this metric had stretched as high as 1.237x! There is certainly no greed or euphoria evident in oil stocks today.

The current third upleg of the oil stocks’ cyclical bull has merely run 35.2% higher at best over 4.9 months. Once again this is too little on both counts for a major upleg. The XOI’s second major upleg peaked at a 59.5% gain after 9.9 months, and its first saw +48.4% after 13.7 months. So like oil, the oil stocks’ current upleg has lots of room to run yet before its performance achieves major-upleg status.

Also like oil, this third XOI upleg hasn’t yet come anywhere close to driving this flagship index to new cyclical-bull highs. Again this is something that virtually all major uplegs in ongoing bull markets accomplish. Technically there is nothing on this chart that looks anything remotely like a major topping yet. The oil stocks haven’t run high enough or long enough to generate the necessary upleg-killing euphoria.

With both oil and oil stocks having plenty of room to run yet technically, there is no need to start realizing profits. Remember the greatest gains in commodities stocks tend to accrue rapidly in uplegs’ final couple months, when greed and euphoria ignite big speculative inflows. The best odds for successfully maximizing your realized gains in an upleg are found in sitting tight until overboughtness metrics are reached.

These oil and XOI technicals are reason enough to be bullish on oil stocks today, but this third chart is the icing on the cake. Since oil ultimately drives oil stocks’ profits, and profits ultimately drive stock prices, oil is the long-term fundamental driver of oil-stock price levels. And the ratio of the XOI oil-stock index to the oil price reveals how this dominant fundamental relationship is trending. Today this XOR shows oil stocks remain radically undervalued compared to prevailing oil price levels.

Remember that late 2008’s brutal once-in-a-century stock panic was the biggest discontinuity in the markets we will see in our lifetimes. That fear superstorm so radically altered the psychological landscape that strong reverberations are still being felt to this day. So many investors and speculators were scared out of stocks entirely that it takes some years after such an epic event for the markets to return to normalcy.

The last normal years for defining the XOI/Oil Ratio were 2006 and 2007, before the panic, which also happened to be late in the previous cyclical stock bull much like where we are today in our current one. Over that span, the XOR averaged 17.9x. In other words, the XOI oil-stock index tended to close at just under 18x the price of crude oil on an ongoing basis. There is no reason not to expect this pre-panic average to eventually be regained.

Incredibly, this week the XOR was merely trading at 12.3x! Relative to the commodity that drives all their long-term fundamentals, oil stocks were only trading at about 2/3rds of their pre-panic levels! This is mind-boggling, all the apparent oil-stock strength in recent months was merely an illusion. As the XOR’s downtrend shows, oil stocks have been losing ground to oil on balance ever since the stock panic.

But this downtrend is certainly not set in stone. When investors and speculators start getting enthusiastic about this somewhat-forgotten sector, they can quickly bid up oil stocks to reflect fundamental realities. This happened early last year as oil stocks’ second major upleg of this post-panic cyclical bull started approaching its climax. By February 2011, the XOR shot as high as 15.8x before it collapsed again!

To merely regain that 15.8x seen near the end of the last major oil-stock upleg, the large-cap oil stocks of the XOI would have to soar 28% from here. To hit the 17.9x pre-panic average, the XOI would need to rocket another 45% higher. And these numbers assume oil stays flat, if it rallies they grow. Relative to oil, the XOI is nearly as undervalued now as it has been at worst throughout this entire post-panic period. Sooner or later a massive catch-up rally is inevitable.

Could these low post-panic XOR levels be the new norm? Sure, anything is possible. But I really doubt it for several reasons. So deeply scarred by the stock panic, retail investors have largely been absent in the past several years. Fund managers often lament this fact on CNBC. But eventually, all those ostrich investors cowering in cash on the sidelines are going to get tired of inflation eroding away their capital after zero yields. They’ll be back, and will want to own oil stocks again.

And even if they foolishly hide in cash forever, new investors are being minted every day. As younger people enter the stage of their lives where they can consume less than they earn, many will invest the surplus. And given oil’s incredibly-bullish global fundamentals (major new supplies are harder and harder to find despite relentlessly-growing world demand), I suspect oil stocks will be high on investors’ lists.

Finally consider silver. Before the stock panic it had a certain relationship with gold, its primary driver. Afterwards, this metric was way too low. So I started arguing in early 2009 that a massive mean reversion was inevitable, silver would have to soar. I kept advancing this argument, taking flak each time. But indeed in early 2011, investors finally did return to silver in a massive way. They not only drove silver’s ratio with gold back up to its pre-panic average, but well above it! Fundamental mean reversions are inevitable.

And perhaps the most exciting part of all is we don’t have to buy the gigantic XOI oil companies. As of the end of last month, the XOI’s 13 component stocks had average market capitalizations of $124b. This is enormous! Much like oil supertankers, giant companies have tremendous price inertia. The bigger a company gets, the more buying it takes to move its price higher. Giant stocks are slow to rally.

Thanks to technologies now being perfected including horizontal drilling, hydraulic fracturing, enhanced oil recovery, and rising oil-sands efficiencies, there are a growing number of fantastic oil companies that are far smaller in market-cap terms than the majors. While $1b of buying will barely budge a $400b monolith like XOM, it can catapult a $10b company way higher. These emerging oil plays have incredible potential to soar.

Last summer as oil was correcting, we undertook a 3-month deep-research project looking into the mid-cap oil stocks trading in the US and Canada. They had market caps ranging from $2b to $10b, a highly-leveraged sweet spot. After spending hundreds of hours narrowing down the entire population to our dozen favorites, we profiled each in depth in a fascinating 36-page fundamental report. It is from these elites we drew our oil-stock trades during last year’s correction, and their already-nice unrealized gains ought to only accelerate from here.

Today this report is available for only $45, an incredible bargain for such world-class research. While the gains buying now in the middle of an upleg won’t be as large as from buying early like we and our subscribers did, there is still plenty of upside left in oil stocks. Since most of this sector’s gains in an upleg tend to accrue rapidly in its final months, there is a good chance that less than half of the total gains have been won so far.

At Zeal we are hardcore contrarians, we buy low when others are afraid (like last autumn) and then later sell high when others are brave (likely later this spring). While not easy psychologically to fight the crowd, the results are well worth the challenge. Since 2001, all 598 stock trades recommended in our subscription newsletters have averaged stellar annualized realized gains of +48%! You too can share in the very-profitable fruits of our labors.

We publish acclaimed weekly and monthly subscription newsletters loved by speculators and investors all over the world. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, where they are likely heading, and how to trade them with specific stock trades as opportunities arise. Subscribe today and start thriving!

The bottom line is neither oil nor the oil stocks look anywhere close to being overbought yet. Their uplegs remain too small and too young to be topping, with new bull-market highs still yet to be seen. By their own bull-to-date standards, both oil and oil stocks still have lots of room technically to run higher yet. So it is certainly way too early to be looking for a major topping, or prematurely realizing oil-stock profits.

Oil stocks’ best gains tend to accrue rapidly in the final months of major uplegs. And their third major upleg of this cyclical bull is likely nearing that glorious terminal phase. While the major oil stocks should see nice gains, the best of the smaller ones are likely to soar. Growing enthusiasm will entice in capital, accelerating the stock-price rally that will eventually ignite euphoria. That will be the time to sell high.

Adam Hamilton
March 10th, 2012

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