Oil stocks have been one of the few bright spots for the S&P 500 (SPY), during the pessimistic bear market period of 2022. However, that party may soon be coming to an end. Below, I outline 3 reasons why oil stocks are no longer a buy, and reveal how you can still profit from oil stocks as they pull back from their recent highs. Read on to find out more….
Oil stocks have been the only place where they have seen serious gains over the past year. But even the energy names look tired and toppy after a frenetic rally at current levels.
Looks like it’s finally time to take some profits and position yourself for a big oil pullback…
For our discussion, we will use XLE, the Energy Select SPDR ETF, as a proxy for oil stocks. XLE’s two main holdings are oil majors ExxonMobil (XOM) and Chevron (CVX). Together, these two elements account for more than 42% of the ETF’s weighting.
Oil inventories have been overbought but are weakening
The one-year price chart below shows the price action for the XLE. As you can see, XLE hit overbought levels on Wednesday before falling sharply. The 9-day RSI hit 80 and then pivoted. The MACD approached an extreme before softening. Bollinger Percent B approached 100 then fell.
The shares were trading at a large premium to the 20-day moving average. On previous occasions, these similarly aligned indicators marked significant mid-term highs for oil stocks.
I have also highlighted the magnitude and duration of the previous two rallies (purple lines). Note how they coincide almost identically with the current price action in XLE.
Oil inventories expand relative to overall inventories
The yearly chart below of oil stocks (XLE) versus the S&P 500 (SPY) shows just how far XLE’s outperformance has reached across stocks. The XLE is posting a robust gain of just over 60% over the past 12 months, compared to a loss of nearly 17.5% for the SPY.
Remember that major oil stocks such as ExxonMobil and Chevron are also part of the SPY, which makes the comparative performance even greater once the oil names are removed.
Interestingly, the last time oil stocks hit such highs in early June led to a significant decline, or mean reversion, in XLE. Expect a similar scenario to unfold, with XLE relatively underperforming against SPY over the next few months.
Oil inventories are ahead of oil itself
Oil and oil stocks tend to be well correlated. It certainly makes intuitive sense. If crude goes up, oil inventories should follow and vice versa.
This was certainly the case for the first half of the year, as the graph below shows. Oil and oil stocks hit highs in early June, with West Texas Intermediate Crude ($WTIC) prices trading well above $120 a barrel.
Since then, however, we have seen $WTIC pull back sharply below $90 a barrel while XLE hit a new high. This divergence is today pushed to the extreme. XLE now outperforms $WTIC by more than 50% in the past 12 months.
I expect oil stocks to start falling in sympathy with lower oil prices late in the year.
Traders and investors looking to position themselves to take advantage of the XLE’s anticipated convergence to lower levels can buy puts and spreads on oil stocks or sell bearish call spreads out of the money. This is exactly what we did recently with a diagonal put on ExxonMobil (XOM).
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Good trade!
Tim Biggam
Editor, POWR Options Newsletter
SPY shares were up $4.99 (+1.34%) in premarket trading on Friday. Year-to-date, SPY is down -20.33%, versus a % rise in the benchmark S&P 500 over the same period.
About the Author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Chief Options Strategist at ThinkorSwim and 3 years as a Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade “Morning Trade Live” network. His primary passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the POWR Options newsletter. Learn more about Tim’s journey, as well as links to his most recent articles.
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