Don’t Fight the Trend: Energy Edition

COVID hit the U.S. Energy sector hardest of all earlier this year. With global activity grinding to a halt as a result of widespread shutdowns, demand for crude oil disappeared. In a market where supply and demand are held in a delicate balance, oil prices predictably fell. But the extent of the decline was nearly unthinkable.

Light Sweet Crude Oil trades on the Chicago Mercantile Exchange (CME) in the form of a futures contract. Unlike stocks, which are shares of ownership in a company, futures contracts are legally binding agreements to buy or sell a particular asset at a predetermined price and date. They’re incredibly useful for producers and consumers of commodities. (Consider a corn farmer, whose livelihood depends on the price he receives. Instead of going to market at harvest and hoping for the best, he can sell a futures contract for corn several months ahead of time. He may not receive a higher price, but the certainty of price allows him to plan accordingly.) But the futures markets aren’t limited to just producers and consumers. Speculators, whose only concern is to profit from changes in price, necessarily provide liquidity to the markets. However, they take care to never be long or short a futures contract at its settlement day, lest they get a bushel of wheat delivered to their front door.

And so the price of crude oil went negative in April 2020.

Oil demand fell faster than producers could slow production, and oil inventories rose rapidly – so rapidly that the world ran out of places to store the stuff. As the May contract neared settlement, those who were long contracts got caught holding the bag. Either they took delivery themselves – an impossibility for speculators – or they paid any price to find someone who could. The day before settlement, West Texas Intermediate traded at a previously inconceivable negative $40 per barrel.

Energy stocks took a similar path after the onset of the virus, dropping 62% from their January highs. But by the time prices reached their lows in mid-March, momentum was already improving. The signal was confirmed by another positive divergence – as oil prices fell below $0, the price of Energy stocks continued to rise. The rally was on, and in less than 3 months, the Energy sector had doubled from its low.

For everyone watching in real-time, that was a tremendous show of strength. Energy outperformed every other sector over the period, and the eye-popping returns were hard to ignore.

Subsequently, the U.S. stock market has looked past the coronavirus and reached new all-time highs. Meanwhile, the Energy sector has done nothing but fall. Just last week, it breached an interim support level and dropped to 5-month lows.

Mr. Market decided to remind us of an all-important concept in technical analysis: Every trend change starts with a mean reversion, but not every mean reversion changes the trend. By definition, a trend is more likely to continue than to change. In this case, Energy stocks reverted to the mean and nothing more.

If you’re wondering why this principle applied to Energy, but not Technology, or other sectors damaged by the pandemic, consider this: Energy stocks were in a downtrend for more than 5 years before anyone had even heard of COVID-19.

The coronavirus exacerbated the half-decade trend, but it didn’t create it. Alternatively, every other sector was at or near multi-year highs in January.

None of this means that Energy has to go down and break the March lows. That could certainly have been the bottom. But with prices below a falling 200-day moving average and setting incremental lows, this sector is not in an uptrend.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

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