SOLR - XLE: Saudi Arabia Sends A Message

2023-06-05 07:00:33 ET

Summary

• Energy investors have endured significant volatility over the past two months as China's economic recovery has fizzled out.
• Saudi Arabia decided to cut its production, demonstrating its commitment to defend oil prices from falling further, lending stability to the market.
• However, OPEC+ members are mixed in their responses, as lower oil prices could crimp revenue further if they reduce their output.
• Energy investors need to assess the developments carefully, as XLE's recent price action has closely tracked underlying oil prices.

Investors in The Energy Select Sector SPDR ETF ( XLE ) have had to manage significant volatility over the past two months since our update . We urged investors to buy the steep selloff in March as the market worried about the banking crisis.

While XLE's March lows proved to be a buyable dip, as the XLE rallied through its April highs, sellers returned even as Saudi Arabia led an OPEC+ production cut in early April. As such, the XLE has dropped toward lows last seen at the end of March, as energy investors worry about the health of the global economy.

As such, the additional 1M barrels per day or BPD production cut in July initiated by Saudi Arabia in the OPEC+ meeting over the weekend will be assessed carefully by market operators.

Energy bulls could have been disappointed that the additional cut was anchored solely by Saudi Arabia. Brent crude oil futures ( CO1:COM ) are still hovering close to the psychologically important $70 support levels. Therefore, energy buyers likely hope the Saudi put is sufficient to discourage bearish speculators from intensifying the selling pressure.

Saudi Arabia oil minister Prince Abdulaziz bin Salman called it the " Saudi lollipop. " Prince Abdulaziz has recently been vocal on taking the fight to the bearish speculators, warning them to " watch out. " However, Saudi Arabia did not unveil its strategy moving ahead, although it highlighted that it aims to seek " price stability " in the market. As such, I believe the kingdom is keeping its cards very close to its chest, as it aims to thwart the efforts of the bearish investors with surprises.

The XLE has underperformed the S&P 500 ( SPX ) ( SPY ) since our rating upgrade in March. The weak momentum in China's nascent post-COVID economic recovery affected buying sentiments in energy stocks. As such, leading players such as Exxon Mobil ( XOM ) and Chevron ( CVX ) have underperformed the SPX, as value stocks took a backseat as investors rotated toward stocks participating in the AI hype.

However, I believe investors must reassess the opportunities in the XLE with more optimism and pessimism. I assessed that the valuation in the energy sector had improved markedly over the past few months.

As seen above, we are no longer overvalued, as astute sellers took profit at the end of 2022, cutting their exposure and rotating into risk-on sectors. As such, the over-optimism seen at the heights of the energy sector mania has cooled down markedly. I also highlighted these risks in my previous articles on the XLE, with two Sell ratings in December 2022 and February 2023 .

Hence, weak holders who didn't anticipate the warnings from XLE's price action and bought those highs from the astute sellers could also have bailed out, intensifying the recent selling pressure.

Energy analysts are also mixed in their outlook, much less bullish than in 2022 . Keen investors should recall that Goldman Sachs ( GS ) upgraded its base case oil forecast to $135 in early March 2022, with a bull case of up to $175. JPMorgan ( JPM ) stoked even more bullish sentiments then, topping Goldman's target with a $185 bullish case.

Well, we will know what happened. Brent topped out at the $139 level in early March 2022. It then closed 2022 at the $80 level, considered critically important to Saudi's long-term plans to fund its economic transformation.

At writing, Brent is trading at the $76 level, nowhere close to the targets put out by the oil strategists from Goldman or JPMorgan (a reminder that no one has a crystal ball).

For now, Goldman Sachs is less "grandiloquent" with its forecasts. Its energy strategists believe that the "OPEC+ meeting was moderately bullish and offset some bearish downside risk to the bank's December forecast of $95 a barrel." The highly optimistic commentary was markedly missing, and I think that's good news for contrarian investors.

For investors who were stunned in 2022 as they bought the highs, expecting more "greater fools" to buy the overvalued sector then, it's not the time to bail out now. The time to run was late last year when they had the best opportunities to sell at a high. If they sell now, with the sector seemingly undervalued, the risk/reward is likely not in their favor.

Even if they want to cut exposure, they should consider waiting for a near-term spike, as speculators attempt to price in the recent OPEC+ meeting before getting out. Sell the rip, but don't sell the pullback.

The XLE was defended by energy buyers last week, as they likely anticipated positive action from OPEC+. The "Saudi lollipop" should help to stanch near-term downside risks.

Based on XLE's price action against the underlying Brent crude, I assessed that it's essential for energy investors to consider whether they have confidence in the ability of OPEC+ to mitigate downside risks.

The internal squabbles in OPEC+ recently highlighted the struggles from falling oil prices, as smaller producers could be hampered further if they were being "compelled" to cut production further.

As such, Saudi's leadership role will likely be tested in future meetings, which could deter some energy bulls from returning. In addition, energy investors might be concerned whether Saudi Arabia could muster enough influence to keep its peers satisfied if downside risks persist.

Hence, while I assessed that the risk/reward remains favorable, investors must be ready to be patient for the macroeconomic headwinds to subside, particularly in China. China's growth story is still predicated on a second-half recovery, which will likely be fundamental in helping to stem further weakness in the US and Europe.

Notwithstanding, I must caution that XLE's price action is increasingly worrying if it fails to regain bullish momentum above its 50-week moving average or MA (blue line).

Suppose sellers can establish a critical resistance zone at the $80 level over the next four to eight weeks. In that case, investors should consider cutting exposure and staying out, as the medium-term uptrend could reverse to a downtrend.

Rating: Speculative Buy (Reiterated). See additional disclosure below for important notes accompanying the thesis presented.

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