Is it a good time to buy oil and short energy stocks?
Multiple articles are coming out on the divergence between oil stocks and the price of oil. The chart below shows why it’s being talked about – the price of oil has fallen over the past few months, while energy stocks, as represented by the Energy Select Sector SPDR (XLE), hit multi-year highs.
This seems like a good time to buy oil and short oil stocks, which is a bet that prices normalize against each other. In the analysis below, I will examine how these assets have performed in the past when energy stocks have outperformed oil by such extreme amounts.
Energy stocks outperform oil prices
I went back to 1999 and calculated daily the three-month relative strength of the XLE against the spot price of oil. Over the past three months, Oil has lost around 7%, while XLE has gained around 12%. These are big moves in opposite directions, putting the relative strength in the 92nd percentile of the readings. The chart below shows how the XLE, which is an approximation of energy stocks, fared after relative strength readings were in the 90th percentile.
For prices to normalize, the price of oil must rise or oil inventories must fall. According to the data below, past cases do not show a decline in oil prices, with returns looking relatively normal. Six-month returns after relative strength readings in the 90th percentile show average gains of 3.54%, with 62% of the returns positive.
Since 1999, the XLE has generally gained 3.97%, with 62% positive returns. A year after these instances, oil tended to do better than normal oil returns (11.59% vs. 8%).
If oil inventories do not fall, oil prices must rise for prices to return to normal. The table below shows that this is what usually happened. After oil stocks outperformed over three months, oil tends to catch up going forward.
Six months after these examples of XLE outperformance, Oil is showing an average return of more than 26% over the next six months, with 81% of positive returns. Oil normally gains about 7% over six months with 62% positive returns. A year later, oil has gained an average of 42%, compared to a typical return of 13% for oil.
I noticed that a good chunk of the signals happened in 2020 and wondered if the conclusions would change if we got rid of those signals. The first chart shows XLE’s performance after these signals, excluding those in 2020. The second chart shows the same data for Oil.
The conclusion is the same, with nothing special about the XLE returns. Oil returns are less extreme when you strip out the 2020 signals, but they’re still impressive and far outperform normal oil returns.