Energy Equities and Brent Disconnect

Ok guys, for those of you that didn't listen on my VIX call a month ago, here's another gem for ya.

Look at Brent, it's at 104 (forget about WTI, it's useless right now). Meanwhile, energy equities have gone off a cliff (look at XLE and OIH). This is unsustainable. If Brent stays at these levels, then energy equities are way too cheap. Meanwhile, if the economy is going to shit, then energy equities are fairly priced but Brent is too expensive.

Short Brent and long energy equities. You need to be big enough to trade Brent futures, but it's an attractive risk/reward trade imo. Relative mispricing should correct itself over the next year.

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One of JPM's equity strategists recommended energy stocks as oversold and called for them to rally relative to the rest of the market.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
 
Kenny_Powers_CFA:
One of JPM's equity strategists recommended energy stocks as oversold and called for them to rally relative to the rest of the market.

Yup, energy is a defensive sector that occasionally trades like a cyclical. But I know one thing is true, we keep needing more energy, and we keep depleting our reserves. Screw the short-term volatility, it's the safest sector from a fundamental perspective (well, other than maybe agriculture).

 
Best Response
proforma:
Why exactly do you think energy equities are cheap vs Brent? Im not an e&p guy but im curious if you have any metrics to back this up. Also, while WTI may be less relevant, not everybody is getting Brent pricing, usually a regional rate based on infrastructure capacity .

I've seen enough research reports to know what price expectations are for the equities relative to the oil price Obviously the sensitivity of each equity to the oil price varies based on their corporate profile. Feel free to plot the spot price and the equities prices and see what conclusions you draw.

All the other benchmarks are closer to Brent than WTI, adjusting for the characteristics of their crude. The only one for which this is not holding is WTI, because all the new Bakken and oil sands production is creating a glut at Cushing for which there's not enough transport capacity. Oil is extremely fungible and easily transportable, except for WTI in the last few months.

$104 is a very high price, these companies still make a lot of money at that price. I think the equities have traded as if Brent (i.e. global oil prices) were at $80...I think it's a psychological thing from seeing "oil $80" on TV and in the news all the time, but it's really "oil $100".

 

This looks like a pretty good trade to me. Which version would you reckon would work best, XLE or OIH? Fwiw, just ran a couple of regressions and looks like XLE has marginally more juice in it (and also a slightly better R^2 with CO1). What do you think the right beta / hedge ratio is?

Also -- looks like this apparent dislocation is there whether I look at XLE vs Brent or vs WTI. So it seems to me that it cant just be a psychological "oil at $80" thing with everyone confusing Brent and WTI. Any other thoughts on what else may be behind this? Just more deleveraging in equity space than in commodities perhaps?

Anyways, it looks pretty decent, think I might actually take a stab at putting this one on for my PA...

 
tyfly:
This looks like a pretty good trade to me. Which version would you reckon would work best, XLE or OIH? Fwiw, just ran a couple of regressions and looks like XLE has marginally more juice in it (and also a slightly better R^2 with CO1). What do you think the right beta / hedge ratio is?

Also -- looks like this apparent dislocation is there whether I look at XLE vs Brent or vs WTI. So it seems to me that it cant just be a psychological "oil at $80" thing with everyone confusing Brent and WTI. Any other thoughts on what else may be behind this? Just more deleveraging in equity space than in commodities perhaps?

Anyways, it looks pretty decent, think I might actually take a stab at putting this one on for my PA...

For all intents and purposes, OIH and XLE should give you very similar results. XLE is slightly less volatile. They're very correlated, so decently interchangeable. XLE has easier trading rules on some brokerages relative to OIH.

Based off recent action, the hedge ratio is roughly 1:1. Honestly, it's basically guessing on a trade like this as far as the hedge ratio goes. I don't think this is a situation where calculating a hedge ratio is particularly useful. I'd either do 1 to 1, or overweight the equities, if for no other reason that they give you a positive yield whereas the commodity does not (so since any ex-post error in hedge ratio adds volatility, add it on the asset class that has a positive yield).

Yes the dislocation is there for both, but keep in mind that WTI and Brent used to have essentially no spread, so if you go back to say 2007, 2008, the dislocation is much greater relative to Brent than WTI. I actually think the equities prices would be roughly fair if all crudes were trading at $80. No idea what's causing the dislocation, though there's a lot more technical momentum behind Brent than WTI. At $23, the spread between the two is way too great. Brent has higher margin reqs, so less hot money there.

Btw, instead of doing an ETF, you can also do stock picking. The big integrateds are very cheap right now, trading at 7ish multiples. That's crazy. I'd argue that, long-term, these are safer investments than the Treasuries and other fixed income people have been piling into this week. Names like HES and COP look particularly attractive to me.

Btw, if you make a lot of money off this, PM me and I'll give you my address so you can mail me a nice present ;)

 
alexpasch:
Ok guys, for those of you that didn't listen on my VIX call a month ago, here's another gem for ya.

Look at Brent, it's at 104 (forget about WTI, it's useless right now). Meanwhile, energy equities have gone off a cliff (look at XLE and OIH). This is unsustainable. If Brent stays at these levels, then energy equities are way too cheap. Meanwhile, if the economy is going to shit, then energy equities are fairly priced but Brent is too expensive.

Short Brent and long energy equities. You need to be big enough to trade Brent futures, but it's an attractive risk/reward trade imo. Relative mispricing should correct itself over the next year.

By energy equities do you mean E&P businesses? This is where I have noticed the largest disconnect. September contracts were down roughly 7%, with the E&P's down 8-10.5%. I think the spreads were even larger last week. MRO and HES got hit particularly hard. MRO is down 30+% in the last two weeks.

Do you have any thoughts on the multiples for these companies relative to the price of oil? For example, does XEC at 11x NTM EPS at WTI of $80 make sense? MRO at roughly 6x (Pro Forma for the recent spin)???? I realize these multiples are all dependent upon the price of Crude so the argument is inherently flawed, but some of them seem dirt cheap.

 
Gray Fox:
alexpasch:
Ok guys, for those of you that didn't listen on my VIX call a month ago, here's another gem for ya.

Look at Brent, it's at 104 (forget about WTI, it's useless right now). Meanwhile, energy equities have gone off a cliff (look at XLE and OIH). This is unsustainable. If Brent stays at these levels, then energy equities are way too cheap. Meanwhile, if the economy is going to shit, then energy equities are fairly priced but Brent is too expensive.

Short Brent and long energy equities. You need to be big enough to trade Brent futures, but it's an attractive risk/reward trade imo. Relative mispricing should correct itself over the next year.

By energy equities do you mean E&P businesses? This is where I have noticed the largest disconnect. September contracts were down roughly 7%, with the E&P's down 8-10.5%. I think the spreads were even larger last week. MRO and HES got hit particularly hard. MRO is down 30+% in the last two weeks.

Do you have any thoughts on the multiples for these companies relative to the price of oil? For example, does XEC at 11x NTM EPS at WTI of $80 make sense? MRO at roughly 6x (Pro Forma for the recent spin)???? I realize these multiples are all dependent upon the price of Crude so the argument is inherently flawed, but some of them seem dirt cheap.

I mean upstream stuff. E&P and servicers/drillers both work (for example OIH has no E&P co.'s in it).

Well that depends, as you said, on the price of oil, because that will obviously directly impact NI. I strongly believe that oil goes up significantly in the long-term, so we'll see $100+ again probably within a year or two. As such, I think current P/Es are relevant, even if you see some decrease in net income in the meantime (keep in mind that the overwhelming majority of the value is tied up in the terminal value, and I just see oil prices going up and up).

Generally speaking, tons of screaming buys. Only things I would be cautious with are the smaller cap stuff because there's a lot of company specific risk in those, those require a ton of due diligence.

 

Do you look at hedge ratios at all? Do you think a majority of these companies your looking at are currently hedged somewhat? Personally I think most E&P's never hedge correctly or timely.

Also do you believe in the old-age that energy equities always lag spot prices? Or do you think they are closer correlated in a shorter time frame.

 

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