Oil Bounce or Bottom? I'd Vote for Bounce

02/02/2015 5:33 pm EST

Focus: ENERGY

Jim Jubak

Founder and Editor, JubakPicks.com

Does the big bounce last Friday finally signal a bottom for oil and a turn in the market or simply a bounce triggered by short covering? MoneyShow’s Jim Jubak offers the reasons for why he’d vote for the latter.

Oil bounced big on Friday, January 30 with the Brent benchmark climbing 8% on the day to close above $50 a barrel. And West Texas Intermediate and Brent are both up again today, strongly, to $49.78 a barrel and $54.78 a barrel, respectively.

Does Friday mark a bottom for oil and a turn in the market? Or is it simply a bounce, triggered by short covering?

I’d vote for the second alternative. In my opinion, the fundamentals haven’t turned and it still looks like we’ll have to test $40 on West Texas Intermediate—about 10% below the January lows—before we see a real bottom.

Of course, a drop of 10% from here isn’t all that big a decline in comparison to the 50% to 60% plunge in oil prices we’ve seen so far. I think we’re getting closer to a bottom, and in my opinion, we’re close enough to the bottom so that selling everything in the sector on this bounce doesn’t make a great deal of sense. That said, though, there are a few stocks that set up as interesting trades in this bounce, if you’re a good enough trader to get out and then back in when the time is right.

News that US producers had idled almost 100 rigs last week, the biggest drop on record, set off Friday’s rally. US rig count dropped to 1,223, a three-year low, according to Baker Hughes. That brings the eight-week total of idled rigs to 352.

That news was so powerful because two weeks of sideways action in the oil markets had set up an intriguing trade. Hedge funds—and other money managers who have moved massively short oil as the plunge continued—now saw the possibility of a reversal when they looked at their charts. Short bets in the futures and options markets had jumped 11% in the week ended January 27, according to the Commodity Futures Trading Commission, to 104,763 contracts, the most since 2010.

It looks like many of those shorts simply decided to cover, taking profits, and giving themselves time to see where the trend might be headed. With oil prices at a six-year low, the odds of a bounce had climbed to a point where some shorts decided to close their trades. That protective move, of course, set off exactly the bounce that traders were worried about.

For this bounce to turn into something with staying power, oil markets will have to see some evidence that the gap between oil supply and demand is narrowing. And despite the drop in US rig count, there isn’t much evidence of that, yet.

True, US gasoline consumption has averaged more than 9 million barrels a day for the last month, but despite the drop in operating rigs, US oil production is still climbing, reaching a 31-year high of 9.2 million barrels last week. US stocks of commercial crude rose to the highest level since 1931.

So far, it looks like US producers are idling the lowest yielding rigs and holding their activity in high production geologies steady, or even increasing it slightly. That has kept production trending upward even as the rig count has dropped.

OPEC shows no signs of cutting production. In fact, some OPEC members actually increased production in January. Angola and Nigeria, for example, both upped out in January.
 
All this suggests that after the bounce drives prices to a level that makes shorting again a high probability trade, we’ll see the market reverse and head back down at least to the $43 to $44 a barrel range for West Texas crude and to $6 to $47 for Brent. At that point, the markets are likely to see a test: either those prices will hold, in which case, we can start seriously to talk about a bottom, or prices will fall through those levels and we’ll test the psychologically important $40 a barrel level for West Texas Intermediate.

This frustrating process of plunges and bounces—interrupted by the occasional week or two of sideways action—is how a market puts in a bottom. If you had resolved to hold onto your energy positions through all this pain, you are getting near a point where that decision will become much less painful. I’m still looking for a recovery in oil prices and in the prices of oil stocks in the second half of 2015. We’re not there yet, but I think we are making progress. (The big question then will be how far the recovery will take us. $65 a barrel certainly seems probable in the second half of 2015. $100 a barrel seems unlikely.)

For others more inclined to trading—and better at it than I am—this bounce sets up some interesting possibilities. Note that the stocks that had bounced the highest are exactly those that were hit the hardest. Today, for example, a relatively under-leveraged deep sea driller such as Ensco (ESV) closed up 3.01%, while a relatively over-leveraged driller such as Seadrill (SDRL) was up 10.24%, and a production company with big shale exposure and high levels of debt such as Chesapeake Energy (CHK) was up 6.83%. If you’re going to trade this bounce and the likely plunge after the bounce has peaked, I think you want to target those big worry, big movers both long and eventually again short.

I hold shares of Ensco, Seadrill, and Chesapeake Energy in my Jubak’s Picks or Dividend portfolios.

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