My Feelings On Energy

• May 21, 2004
• Mark Boucher

Energy in a
Secular Bull Market

Over the last year energy plays
have crept into our stock-lists as more and more energy companies meet our
criteria. Currently Exploration and Production companies have more stocks
meeting all our criteria than almost any other industry. So what’s the outlook
for energy stocks?

First, investors should
understand that energy stocks in general have had a good move up and that there
are several indications that a correct ion is brewing in the short to
intermediate term. Therefore while we think energy is an excellent long-term
secular theme, investors should be a bit more cautious than usual about putting
too much allocation into this segment right now.

Oil prices have surpassed the
40 level, and this level has led to oil price reversals in 1990, 2000, and 2002.
A breakout above 42 basis crude will setup another advance, but this is probably
not in OPEC’s near-run interest as prices above 42 tend to choke off global
recoveries. Right now speculators are holding huge net long positions in crude,
which is short-term bearish from a contrary opinion perspective. In addition
global growth has peaked and is cooling. China has been the swing consumer in
this cycle and Chinese growth is slowing, with a soft-landing expected at least.
World oil production, led by Russia, has actually expanded faster in the last
few years than demand has. In addition, the expansion of US Strategic Petroleum
Reserves (SPRs) has been an impetus to oil demand. Yet SPR’s are getting close
enough to full that aggressive further stockpiling is not likely.

Thus there is reason to expect a correction in oil prices and in energy stocks
will develop as some of the above forces play out. Despite the near-run outlook,
the long-run secular price trend for energy stocks and oil prices is likely to
be up, and energy remains one of the better long-term themes of the coming
decade. While production is indeed rising, the ratio of total reserves relative
to consumption is dropping – meaning oil is becoming increasingly scarce. The
era of low energy prices from the 80’s to 90’s is probably ending. Demand is
exploding particularly from the emerging market world. Leading economic
indicators point to continued global growth. Developing Asia in particular has
become the key swing consumer, and industrialization of this region promises the
prospect of ever-rising demand for oil. Geopolitical stability in the oil
producing region seems much less likely ahead than it did in the ’80’s and 90s.

^next^

For these reasons, we believe
any near-term corrections should be relatively mild both in crude prices and in
energy stocks. Should a correction develop, we would advise investors to use it
as an opportunity to accumulate energy shares – particularly if they can rally
broadly and strongly with good volume off of support. We would look for oil to
find support somewhere in the 30-35 range on corrections as long as the recovery
is intact.

Oil service stocks should also
do well longer-term as global active rig count is booming and has room to
continue advancing.  Thus investors should watch integrated oils, oil service
stocks and E&P stocks for breakouts and as a group to buy for longer-term
appreciation, and if a correction develops in oil prices over the coming months.
While longer-term investors will get greater returns from utilizing our stock
lists to build an energy portfolio, investors also have access to ETF’s like XLE
and IYE.

 

So far our US long/short model
has been relatively inactive during 2004, and we continue to suggest investors
use some caution until stocks meeting our criteria expand in breakout breadth.
 Investors should continue to cautiously add stock exposure as trade signals are
generated that meet our strict criteria, as well as allocate to our favorite
segments on breakouts and signals as advised above.  With our model portfolio
having been essentially in cash since November, it has been frustrating for many
— but market environments like March and April make this position seem wise. 
These are tough markets and traders must be nimble and willing to wait for good
odds to risk capital.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops
levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in
2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May
2003 (strict following of our US only methodologies should have had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%.   This did not
include our foreign stock recommendations that had spectacular performance in
2003.>

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 6, 11, 12, 16, and 24 with 3 breakouts of 4+ week ranges, no
valid trades and no close calls.  Upside breadth has deteriorated to neutral
during the past two weeks.  Position in valid 4+ week trading range breakouts on
stocks meeting our criteria or in close calls that are in clearly leading
industries, in a diversified fashion.  This week, our bottom RS/EPS New Lows
rose from the depths, registering readings of 7, 9, 20, 15, and 11 with 7
breakdowns of 4+ week ranges, no valid trades and no close calls — breadth on
the short-side was disappointing this past week, but breadth has improved
remarkably in the past weeks, and we are eagerly looking for stocks that meet
our downside criteria. 

For those not familiar with our long/short strategies, we suggest you review my
book
” The Hedge Fund Edge,” my course “The
Science of Trading,” my video seminar, where I discuss many
new techniques, and my latest educational product, the interactive training module. Basically,
we have rigorous criteria for potential long stocks that we call “up-fuel,” as
well as rigorous criteria for potential short stocks that we call “down-fuel.”
Each day we review the list of new highs on our “Top RS and EPS New High List”
published on www.TradingMarkets.com for breakouts of four-week or longer flags, or
of valid cup-and-handles of more than four weeks. Buy trades are taken only on
valid breakouts of stocks that also meet our up-fuel criteria. Shorts are
similarly taken only in stocks meeting our down-fuel criteria that have valid
breakdowns of four-plus-week flags or cup and handles on the downside. In the
U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new long signals and sell short new short signals until our
portfolio is 100% long and 100% short (less aggressive investors stop at 50%
long and 50% short). In early March of 2000, we took half-profits on nearly all
positions and lightened up considerably as a sea of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally. 

We continue to advise keeping allocations low until the trend is more certain. 
Preserve capital until a more reliable trend develops.

Mark Boucher