For the past few week, our algorithm designed to help us find stocks that are going to rally, fall or trade sideways was signaling trouble in the oil patch. That system looks at the behavior of share price action of individual stocks and then puts that security in the appropriate category for greater review. The system does not consider sector issues per say, but when most of the names in a sector begin to align, we take notice.
In digging deeper into the oil & gas sector, it is important to understand what the speculators and hedgers are doing. The following chart shows the price of West Texas Intermediate Crude along along with the commitment of Traders data provided by the CFTC. The commercials (producers) are in the business of producing oil & gas and it is reasonable to believe that they have more insight into the oil markets than a financial participant. With speculators taking on extreme long positions, one might think that a change in trend was at hand.
For the past few months, we have been temped to take a short position in the oil markets and in the stocks of the exploration and productions companies that produce oil & gas. But the price of oil continued to hold up. It was behaving like it wanted to trade an an elevated plateau in the mid $50s, so we continued to wait. At the same time, we felt investors were probably becoming complacent.
The chart above shows the volatility of returns on crude oil going back about 6 years. We thought this was rather curious, because the amount of oil in storage (see our article on Anadarko Petroleum publisher on March 7, 2017) is at historically high levels. Nobody seemed to care that there was a glut of oil sitting in storage. Since we did not have any recommendations in the oil & gas sector, we suggested investors take a look at a short call-spread on Anadarko. In our view, the company looked overpriced in a $54 oil environment and the share price was taking on a bearish tone.
Now that the price of oil has begun to break down and is now trading below $49 a barrel. This is the first sign that oil wants to trade lower. If and when the price breaks the lower trend line of the contracting triangle, sharply lower prices and higher volatility are the likely result. Breaking support could be the trigger for liquidation by the speculative longs. If liquidation does indeed begin, will the sellers walk or run to the exits.?
