Sector Rotation in Oil: Is the Well Running Dry?

2017-11-17 | Simpler Trading Team

Every trader needs their own trading plan. Consistent profits are directly linked to a solid trading plan. If you want to improve results,  first look to a trading plan. Most traders lose money because they don’t have a plan. They bet all their money on one idea, hot tip, or theory. Profitable traders, on the other hand, exploit an edge.  

One way to get an edge? Sector Rotation.

If you’re new to trading, sector rotation is a strategy where a trader shifts focus (and funds) from one industry sector to another to target the strongest sectors and avoid the weakest ones. This strategy is based on the idea of market cycles. When traders feel they’re seeing a market top, switching to another sector lets them stay ahead of the market.

Market cycles are very much like business cycles.

The beginning of the cycle is the market bottom, which we can identify by finding a long term low. If a company is at a 52 week low, for example, we can expect shares to rally as the stock goes into bull mode and climbs. That bull mode is the second stage of the cycle. Once the bull run tops out in a market top, (third stage) we’re looking for shares to tumble in a bear run. This is the final stage, ending in a market bottom, when the whole cycle starts over. With sector rotation, the goal is to identify a market top, and exit that sector if seeing another sector experiencing a market bottom.

And right now, oil is showing strong signs of a market top.

When we take a closer look at oil prices, we see that crude has climbed steadily since hitting a low of $27.94 in February 2016. As of this writing, crude currently sits at $56.74 per barrel. This is crude’s highest point since reaching $60 a barrel in June 2015. That price point is a strong resistance point for oil and could signify a market top.

(Chart Courtesy of Macrotrends.net)

On top of chart analysis, there are several reasons to think oil’s bull run might be running out of fuel (no pun intended).

OPEC: Opec’s production cuts over the last year have essentially done nothing to help oil prices rise. Last November, OPEC agreed to temporarily reduce oil output by 1.8 million barrels per day in an attempt to manipulate oil prices higher. The U.S., not a part of OPEC, took advantage of the opportunity — as well as the low price of oil tanker rentals — and boosted U.S. oil production to 1 million barrels per day.

That’s double the pace of 2016.

Also, while OPEC members agreed to cut production of oil, until the actual implementation date, those countries increased production significantly, meaning they are still sitting on reserves. And while some analysts predict a rise in oil prices as OPEC agrees to continue to limit oil production, traders should take that information with a grain of salt. After all, crude has seen sudden drops from surprise inventories on multiple occasions over the last year. Also, while Russia, the largest non-OPEC nation, has agreed to limit oil production the last year, there’s no guarantee they’ll continue to do so. Though OPEC members will keep production down, non-member countries, like the U.S., will continue to accelerate production.

Clean Energy: President Trump has championed the oil industry here in the U.S. But even oil and energy company CEOs admit oil is dying while clean energy is ready to light up the world (pun totally intended).

There’s a long list of utility/energy/oil companies on record backing this up. After Trump pulled the U.S. out of the Paris Climate Accord, American Electric Power Company (AEP) CEO Nick Akins went on record in an interview with NPR in favour of clean energy. He told NPR ““Our investors certainly expect us to really focus on sustainability and de-risk our business. So we continue to focus on that. Secondly, from a customer standpoint, there’s an expectation that we move to that cleaner energy economy.”

BP’s (BP) CEO Bob Dudley also agreed that renewable energy is the future, though not for a long time.  And Shell (RDS) has already announced plans to spend $1 billion a year on its New Energies division. According to Shell CEO Ben Van Beurden, “In some parts of the world, we are beginning to see battery electric cars starting to gain consumer acceptance. “All of this is good news for the world and must accelerate.”

However, it’s not just the CEOs getting behind clean energy, it’s the money.

Thanks to continuing advancement in panel production (looking at you, Elon Musk), solar energy is becoming cheaper, faster, and more efficient than ever before. On top of that, the government continues to subsidize clean energy through tax breaks. Plus, renewable energy is sustainable. That means we aren’t depleting resources in the future, which would them more expensive to harvest as they become more scarce.

So while the oil and coal industry has a prominent role in the history of the U.S., clean, renewable energy looks to own the future.

Lack of Diversification: That whole “don’t put all your eggs in one basket” saying is truer in the market than with anything else. And it’s especially true with oil.

When crude is rising, it’s an appealing target. However, oil is extremely susceptible to sudden crashes due to various reasons such as surprise inventories or declines in usage due to seasonal temperatures. And while those happen, the biggest concern about a collapse in oil for traders is the fact that ETFs and futures are so weighted by just a few companies.

One of the best examples of this is The iShares U.S. Oil & Gas Exploration & Production ETF (IEO). This ETF is considered a safe play because the companies which make up the fund are all large corporations rather than speculative plays. And while there are 53 stocks included in the fund, it’s the top 5 investments that account for 38% of the fund’s concentration. Yes, ETFs are a fund which monitors a specific index or sector, but with such a large skew towards just a few companies, the fund is exposed.

Is it all doom and gloom for oil?

Not necessarily.

As mentioned above, OPEC is renewing its commitment to cut oil production. And although the U.S. makes up 1% of the world’s oil production, the U.S. will continue to double its production and exportation of oil to capitalize on that production cut. Plus, drilling shale and fracking are extremely cost effective oil production methods utilized by the U.S. oil industry, leaving large profit margins for U.S. oil.

On top of oil production, the U.S. oil industry has a big fan in President Trump, who is a vocal advocate of oil and coal. Trump campaigned on a promise of American jobs, and oil employs about 5.5% of all U.S. employment or about 10 million jobs. Mr. Trump continues to go back to that jobs promise and is pushing for deregulating environmental protections and pushing through large oil projects, which benefit the U.S. oil industry.

Additionally, oil prices are still climbing. They haven’t started dropping yet. And truth be told, oil may break $60/barrel and continue to rise.

The moral of the story is this: ride oil while you can, but keep in mind that the industry is showing signs of weakness. If oil hits the market top and slides downward, be prepared to rotate to a new sector showing a market bottom and ready to climb. We’ll post more on this in the future,  so make sure to check back regularly.

If you’re interested in learning in-depth trading strategies, click here to register for John Carter’s FREE upcoming ETF training.