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  1. Home
  2. / Investing
  3. / Energy

How to Play This Short-Covering Rally in Oil

What is driving it, and what to do with your mid- and long-term oil positions.
By DANIEL DICKER Mar 07, 2016 | 11:00 AM EST
Stocks quotes in this article: XOM, SDRL, EOG, HES, DVN, PXD

The huge short-covering rally in oil that we've been expecting since December is happening now in early March, delivering back some of the profits in the selected stocks we've been targeting. Many questions for our energy portfolio emerges: Why is this happening? How much longer will it last? Have we seen the true bottom in oil prices? And finally: What do we do now with our energy investments? 

I've been talking about the macro events that must play out before this bust cycle in energy is over and oil can become a long-term constructive buy. One of the most important that I've touched on has been the necessary destruction of marginal U.S. producers and offshore drillers, clearing away some of the most borderline players to make way for what I've called the "survivors" -- which I have been targeting. 

There has also been a market concentration in trying to find those losers and winners. Huge short positions have been taken in some of the most likely candidates for ultimate bankruptcy, many of which we would agree with, and those shorts have been waiting for the Chapter 7 or 11 drop of equity to zero. Concurrent huge short positions in oil futures have also been registered, mostly by algorithmic players who don't care about numbers -- they will stay short to $20, $10 or $5 -- as long as the trend remains downwards -- and fundamentals can't sway them. 

Two things changed last week.

First, commodities -- not just oil -- found their limits. Copper, iron ore, natural gas -- all have been rallying smartly. The contango in oil I pointed out as the most important sign I needed to signal that the downward trend was over dropped to the smallest level since the first of the year, from $12 to $7:

 

And funds followed suit, beginning their covering of futures positions. 

Secondly, the unbelievable facility for oil companies to access the capital markets continued despite their obvious distress. I'll highlight only two from the last week of the dozens of examples I could list from the most opposite sides of the spectrum in energy: Exxon-Mobil (XOM) managed an $8 billion float of new bonds on Mar. 3, and SeaDrill (SDRL) is restructuring $11 billion in debt while gaining a commitment for a half a billion dollars in new capital from majority shareholder John Fredriksen. 

One of these, Exxon, is the most liquid and seemingly indestructible, but even it is still finding it necessary to float just a bit more liquidity in this market space. Someone there is clearly convinced that "lower for longer" is the correct mantra for oil prices. And SeaDrill, perhaps the most heavily leveraged of all the offshore drillers, still managed to buy itself another year of life before it's bankruptcy needs to be considered.  

My point is that in the energy space, shockingly, money continues to pour in whenever it's being requested. 

The facility of even the most distressed oil company to raise capital, and the least distressed feeling the need to do so, combined with the short covering move in oil futures, rightly spooked the equity shorts everywhere in the oil sector. You might be waiting to see a stock go, rightly, to zero, but if companies are continually able to extend their timelines on that at will, the possibility that oil will recover in time to save them obviously increases the risk in the short position.  

The short-covering panic affected the sector stocks differently, of course -- those with the strongest balance sheets and lowest short commitment rallied the least; those on the other side of the spectrum -- the ones most likely (still) to face Chapter 11 (like SeaDrill) rallied spectacularly. 

But now where are we? There's been a long-overdue, short-covering rally that I've been expecting. So what? And now what?

Here are some things I can say:

Oil has bottomed. We won't see any of the $10 or $20 targets that some have picked. Unless the momentum algorithms regroup and again begin to accumulate (which is easily trackable), we won't even see another $26 retest again, in my view. The contango (again trackable) would have to begin to spike outwards as well.  

Oil still isn't ready to get long-term bullish, yet, either. While this short covering could easily take prices back to $40, that still only gets oil from a ridiculously, unsustainably low price to merely an unsustainably low price. We still need to see a whittling away of producers and drillers before any rally can be sustained. Drillers like SeaDrill have managed to "add wick to their time bomb fuses" but we still await a few of those bombs to explode before we'll be convinced the bear market is turning for good. 

From the group of stocks in my portfolio I've discussed with you over the last few weeks and months, therefore, I'm recommending a 50% shaving of all the mid-term plays (Pioneer Natural Resources (PXD), Devon Energy (DVN) and Hess (HES)), and a full sale of whatever you might have left of SeaDrill. Longer term plays we've been accumulating, including EOG Resources (EOG) and Cimarex (XEC), should remain untouched.

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At the time of publication, Dicker was long DVN, HES and EOG, although positions may change at any time.

TAGS: Investing | U.S. Equity | Energy

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