XOP - XOP And XLE: It's Time To Sell Some Energy Stocks And Reduce Risk

2023-08-10 16:38:38 ET

Summary

• Mixed signals from investor activity in oil stocks are indicating caution after giving a buy signal last June.
• Crude oil prices are oversold long term and, with a relatively high short position by asset manager positions, one should expect crude oil to move higher.
• The low "Puts to calls" ratios for XOP, XLE, and 160 energy stocks indicates caution for energy stocks but not a major sell signal.

This is an update of the June 9th article on XOP and XLE. The mixed signals we're getting from investor activity in energy stocks is making us nervous. While we believe XOP and XLE are headed higher, at least for a short while, we think it might be prudent to sell 25% of positions in XOP and XLE on any rally. The reasons for this are presented in the revised charts below, the same charts that made us bullish on XOP and XLE back in June.

Let's first look at the price of crude oil, which is the underlying asset that determines the price of energy stocks. You can't forecast energy stocks without first forecasting the underlying asset that drives their value.

Crude Oi l

This is a chart of the price of crude oil going back to 2006. After reaching a COVID low of $10 a barrel in the spring of 2020, the price rose for two years reaching a high of $120 a barrel at the start of 2022. It's since been in a year and a half correction highlighted by the green oval.

There is no doubt that the price is oversold long term, and it would be natural to expect an intermediate term rally from current levels. An intermediate term rally is supported by the next chart, which shows the investment position of asset managers who trade oil futures.

Asset Manager Positions and Crude Oil Prices

History shows a close correlation between the short positions of asset managers in crude oil and the direction of crude oil prices. It shows that asset managers are usually wrong, which makes what they are doing useful to know.

History shows when asset manager are from 10% to 15% short crude oil futures, this low level of short selling it's usually at the top when you would want a larger short position.

On the other hand, when their short positions are above 30%, this relatively high ratio usually occurs near price lows when you would want a low short position. We've indicated with arrows the high ratios that normally occur before prices in oil generally start to rise.

You can see the current ratio is near 30%. To us this is positive since it's occurring with the oil market in a long term oversold condition. In other words, the combination of long term oversold and a high short position indicates to us that crude oil prices are going higher.

The "Puts to calls" ratio in 160 energy stocks and two energy ETFs indicate caution

In the bullish June article, we relied heavily on the fact that the "puts to calls" ratios of the two energy ETFs - XOP and XLE - were historically high, which was bullish. This was confirmed by a high "puts to calls" ratio of all 160 energy stocks.

These high ratios have now reversed, and we want to review all three charts, which we now believe indicate some caution with energy stock investments. The first chart shows the "puts to calls" ratio of the largest energy ETF - XLE.

The "puts to calls" ratio has a long history of helping market analysts forecast the stock market that goes back to 1971. The ratio provides insight into what investors are expecting the market to do. When the ratio is high it signals that investors are expecting the market to decline. When it's low, they're expecting the opposite. History shows that prices usually move opposite to their expectations. It has value in forecasting market sectors, like the energy sector, too.

The two black arrows point the moments when the puts to calls ratio went extraordinarily high. A high ratio normally indicates a buying opportunity and the high ratio in May and June is one of the indicators which prompted the bullish June article.

It's clear from the graph that this situation has completely reversed, and we now have a ratio at .7, which we've indicated with a green circle.

While this alone is not sufficient to indicate a top in energy stocks, it is a sign for investor caution. It's a sign that more and more investors are convinced that energy stocks are going higher. As we've said before, we prefer to enter an investment when few investors are interested, and exit investments when the crowd begins to pile in.

XOP "Puts to Calls" Ratio

This same reversal in the "puts to calls" ratio is seen in the second-largest energy ETF - XOP. This was one of the two energy ETFs we recommended in June, and it has performed quite well since that recommendation.

It was the extremely high ratio in May and June, which is indicated by the far right arrow, that prompted our bullish recommendation in XOP. The ratio has now fallen to .72, which is almost identical to the .70 for XLE. Just like the ratio for XLE, this ratio is also approaching the low levels normally associated with a top in energy stocks. But, as mentioned in the previous section, this low ratio is insufficient in itself to indicate a top in energy stocks, but it does prompt caution.

The "Puts to Calls" Ratio of All 160 Energy Stocks

The broadest based "puts to calls" ratio is that of all 160 energy stocks. The large investor base behind this ratio gives it added importance. We've graphed it below and use the price of XOP as the price proxy for energy stocks. This way you can visually see the correlation of highs and lows in the ratio against the price of energy stocks.

We've indicated with four arrows peaks in the puts to cause ratio of 160 energy stocks. It was the high ratio last June the helped confirm the buy signal on XOP. If you look at last June's article, you'll see the same lines.

The current ratio has fallen to .51 and is indicated by the green circle. It's low enough to signal caution regarding energy stocks, but it's not low enough to warrant a sell signal.

Conclusion

After a year and a half decline in the price of crude oil, It's oversold long term and ready for a rebound. This is confirmed by the high short position of money managers in crude oil. The outlook for crude oil remains positive.

The situation with regard to oil stocks is a little more confusing. The low "puts to calls" ratios in XLE, XOP and 160 energy stocks is now signaling some caution after giving strong buy signals two months ago. This is not sufficient to provide a major sell signal in XOP and other energy ETFs, but it does warrant some caution.

We believe the best way to proceed is to reduce by selling 25% of one's position in XOP on any rally, and hold other positions. Then wait for a clarification of the situation with time.

For further details see: