Oil is among the most volatile markets in recent weeks with crude oil futures declining more than 15% in July. After dropping more than 25% from its June high, oil is officially back into a bear market. Analysts generally define a bear market as a decline of 20% or more. Despite the fact that the new bear market has only just begun according to some analysts, there might not be much downside risk for oil. Based on futures prices, it’s likely oil is in a trading range and prices could move between $40 and $50 a barrel for some time.
Trading ranges, and other chart patterns, should be considered rough guidelines. While the lower limit of oil’s trading range is about $40., it’s certainly possible the price could fall below that level. In fact, it did earlier this week, dropping to $39.19 before rebounding. On the upside, a short move above $50 would not necessarily mean the end of the trading range. Trading ranges give us a guideline on what to expect but moves to $39 or $53 don’t mark new trends unless there is decisive follow through. The current range is highlighted in blue in the chart below.
The 2-period RSI is shown at the bottom of the chart. This is a short-term momentum indicator designed to oscillate between extremes. Oscillators, indicators that move up and down in a range oscillating around a center point, tend to be most useful when prices are range-bound. You can see in the weekly oil chart that tops and bottoms in price tend to coincide with reversals in the indicator.
Chart analysis and momentum are technical indicators telling us to expect a trading range in oil. Fundamental analysis provides additional evidence in support of a trading range.
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Some analysts believe prices will fall further because the supply of oil reacts slowly to price changes and the current oversupply is likely to continue for weeks or months. This is at least partly true but reflects a misunderstanding of the complexity of the oil business.
Infrastructure supporting the production of oil changes slowly. It takes time and capital to build pipelines and refineries. When prices are low, there’s little incentive to complete large projects. When prices are high, producers tend to overbuild. Some analysts believe overbuilt infrastructure from the last boom will prevent prices from rising.
It is true that large infrastructure projects are slow to build but small changes in production can occur relatively quickly. Producers can sometimes rapidly increase or decrease production at each wellhead by small amounts. Small changes at hundreds of wells have a significant effect on supply. These small changes are a natural response to price changes and can explain the current trading range.
When prices rise above $50, producers might try to increase production as much as they can. They do this to increase cash flow at the higher price, realizing they have a short window of time to benefit from the higher price. This creates price pressures and prices quickly fall below $50. If prices drop below $40, producers have an incentive to reduce output by a small amount while they wait for higher prices and the decreased supply helps push prices back above $40.
This process can occur instantaneously in the futures market. Traders don’t need to wait for the change in production since they can buy or sell based on the expected changes. This appears to explain the action we’ve seen in oil since the beginning of the year.
Stock market investors can also benefit from this trading range. They can buy energy stocks when oil prices are low and sell when prices move towards the top of the range.
In addition to buying low, investors in stocks can also reduce risk by buying low-priced, dividend paying stocks. These stocks have little downside risk in dollar terms since they already trade at low prices and their income means we could be paid while waiting for the eventual turnaround in energy stocks. To further limit risk, we restricted our search to stocks trading at prices near their book value. In a bankruptcy, a company could end up selling its assets to repay creditors. Companies with a positive book value, in theory, have enough assets on their balance sheet to repay their debt and have some assets left over which could be distributed to shareholders. There can be no assurance that shareholders will receive anything in bankruptcy but buying a stock for its book value or less decreases the risk of loss.
Only three companies passed our screens. There are risks to consider with these stocks. Any of these companies could go into bankruptcy and for that reason it could be best to diversify by investing in at least two of these high risk trades.
ECA Marcellus Trust I (NYSE: ECT) is a Texas-based company with royalty interests for Energy Corporation of America, including 14 producing horizontal natural gas wells and 52 horizontal natural gas development wells. All of the wells are located in the Marcellus Shale formation in Pennsylvania. Royalty interests in producing wells allow ECT to receive 90% of the proceeds from the sale of natural gas attributable to ECA’s interest in the producing wells. ECT receives 50% of the proceeds from sales in development wells.
ECT offers investors a yield of 10.8%. There is a possibility the dividend will be cut, a risk that exists in this and all other high yield stocks. ECT is trading at 63% of its book value.
The rounding bottom pattern shown in weekly chart provides a price target of $2.95.
Hugoton Royalty Trust (NYSE: HGT) holds an 80% net profits interests in natural gas producing properties of XTO Energy in the Green River Basin in southwestern Wyoming as well as the Hugoton area of Oklahoma and Kansas and the Anadarko Basin of western Oklahoma. The stock yields 0.5%, a low yield that appears to be safe in the current environment. HGT is trading near its book value. Over the past five years, HGT has traded with an average price-to-book (P/B) value of 3.36.
Based on the price pattern in the chart, HGT could double. This is a monthly chart and provides long-term targets. It could take a year or more to reach the target.
Seadrill Partners LLC (NYSE: SDLP) owns, operates, and acquires offshore drilling units. SDLP primarily serves large oil and gas companies with drilling rigs under long-term contracts. Its customers include Chevron, Total, BP and ExxonMobil. At the end of last quarter, its fleet consisted of four semi-submersible drilling rigs, four drillships, and three tender rigs. Long-term contracts protect against some risks and SDLP’s revenue has held up better than other companies in the sector. SDLP’s revenue is about 25% lower than its peak in 2013. Other companies have seen revenue decline by 90% or more.
Cash flow from operations has also declined but is still more than enough to cover the annual dividend, which was recently cut to $0.40 a share from $1.95 in 2015. The current payout represents a yield of about 10.3%. While the dividend cut should not have been a surprise, the stock sold off sharply on the announcement.
SDLP trades at about one-third of its book value.
Action to take: Consider investing in one or all of these stocks at the market price. As oil prices recover, it’s possible each of these stocks could deliver gains of 100% or more. If the dividends are cut or eliminated in the future, these stocks should be sold.