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Buy Into the Energy Conundrum

Richard Suttmeier

There's a conundrum in the energy sector.

Most energy traders and strategists project that Nymex crude oil will eventually rise to $100 a barrel. At the same time, Wall Street analysts say that energy stocks are cheap, with many companies trading at levels associated with $50 oil, or lower.

My models agree with the analysts, and suggest that this is a good moment to add to holdings of several oil-related names on weakness.

My model also suggests that crude oil may have peaked at $78.40 on July 14. The number of energy stocks rated a strong buy according to ValuEngine is declining and the slide in share price of buy-rated energy stocks both support my view that crude oil is more likely to trend toward $50 than $100.

I have a contrarian view of the commodities markets.

Most economists and strategists say that the rally in commodities over the past five years is the beginning of a new cyclical uptrend.

I say that the spike in commodity prices is a one-time speculative bubble, caused by low interest rates set by central bankers around the world in response to the 9/11 attacks. This would explain why bubbles in many commodities popped immediately following the Federal Reserve's rate hike to a 5% fed funds rate on May 10.

This also would partially explain the energy conundrum. My model shows semiannual support for Nymex crude oil futures of $70.89. That has become a pivot now that crude has traded below that level.

The change isn't a significant negative unless the contract ends the week below that price. My model also shows quarterly resistance at $77.56 and at the July 14 high of $78.40. Monthly and quarterly resistances are $81.10 and $84.53, which are projected to be the best-case highs; if those prices aren't achieved this quarter, it will suggest a market top.

If you take away the speculative forces still in place because of Fed policy and the oil premium caused by geopolitical risks and the hurricane season, crude oil might now be trading right at my annual support of $51.87 -- in line with where energy stocks are trading.

The energy sector is now at fair value after being 16.3% overvalued at the end of March and 9.6% undervalued at the end of June.

As the sector has cheapened, the number of strong buys has sunk to the current 28, down from 43 at the end of June -- but up from 25 a week ago. It appears that the valuations in the energy sector better reflect where energy prices should trade, rather than where crude oil actually is trading.

The bottom line is that energy stocks continue to cheapen while crude oil stays high, and this supports a topping-out of energy costs led by Nymex crude oil futures.

The Energy Select Sector SPDR(XLE Quote) has tracked the general price trend in commodities, with a 52-week high set at $60.15 on May 11, the day after that Fed rate hike. The trading range low of $50.01 was set on June 13. I show semiannual support at $51.57 with a monthly pivot of $54.96 and quarterly resistance at $60.70. The Energy Select Sector SPDR is above its 50-day and 200-day SMAs of $55.78 and $54.16.

Back on June 28 I set my screen to find energy stocks rated buy or better according to ValuEngine, with a market cap between $1 billion and $5 billion, and also at least 10% undervalued and below their 200-day simple moving average. (Crude oil is above its 200-day SMA of $66.77 and the buy-rated stocks are below theirs, which illustrates how cheap these stocks are relative to the commodity.)

Of these nine stocks, five haven't nosed above their 200-day moving averages since then, affording investors an extended chance to add shares for trading around core positions. Remember, my strategy is to maintain a core position and trade around it, buying and selling shares to capture profits from its volatility.

Encore Acquis(EAC Quote) rebounded 25% from its close of $24.48 on June 27 to a test of its 200-day simple moving average of $30.64 on Aug. 2. Investors should consider adding to positions on weakness to my monthly value level of $23.16.

Grey Wolf(GW Quote) traded above its 200-day SMA on several occasions since June 27, but my semiannual pivots at $7.42 and $7.74 provided a drag that kept the stock below its fair value. The low end of the trading range between tests of the 200-day SMA has been the $6.60 level, where investors should consider adding to this position.

Cheapening Energy Stocks Valuations reflect where oil should trade, not where it is trading
Company/Symbol	Aug. 15 Price	Rating	% UV/OV	Fair Value	Mom	5-Wk MMA	Value Levels	Pivots	Risky Levels	200-Day SMA
Encore Acquis (EAC)	$27.71	BUY	-5.0%	$29.16	RM	$27.67	23.16 M		31.36 S	30.42
Grey Wolf (GW)	$7.15	BUY	-19.5%	$8.88	RM	$7.25	5.77 A	7.42 S/7.74 S	9.12 Q	7.60
Helix Energy (HLX)	$35.60	S BUY	-27.9%	$49.40	RM	$36.51	27.75 A			37.21
Hugoton Royalty (HGT)	$30.10	BUY	-12.9%	$34.56	RM	$29.68	24.95 M		36.62 S	32.40
Helmerich & Payne (HP)	$24.80	BUY	-33.7%	$37.42	OS	$26.98	21.50 A/19.83 A	25.64 S/28.66 S	33.26 Q	31.79
Oil States (OIS)	$29.96	BUY	-29.8%	$42.65	OS	$31.72	none	34.39 M	39.48 Q	35.24
Patterson UTI (PTEN)	$26.72	BUY	-29.7%	$38.02	RM	$26.59	24.93 A	26.16 S/27.65 M	29.93 S/30.61 S	30.80
Rowan (RDC)	$31.22	BUY	-30.9%	$45.19	OS	$33.62	25.34 A	34.16 S/35.22 S	41.60 M	38.92
RPC (RES)	$20.78	S BUY	-26.4%	$28.33	F	$21.74	16.42 A/14.55 S	21.30 S	25.74 Q	24.15
Key: OB, overbought; DM, declining momentum; RM, rising momentum; OS, oversold; M, monthly; Q, quarterly; S, semiannual; A, annual. A value level is a price at which my models project that buyers will emerge; a risky level is a price at which investors are likely to reduce holdings, according to my models. A pivot is a value or risky level that has been breached in its particular time horizon; the stock will likely trade around this pivot. Source: Global Market Consultants