This article originally appeared earlier today on ETF Profits.
The decline in basic materials and commodity names, due to slowing growth in China, has created enough weakness in the energy sector to generate an intermediate-term oversold signal in the group. The energy sector is the weakest group internally in the market for this time frame, despite the strength in crude oil prices. This is an unusual divergence, which we don't expect to persist. The oversold signal in the group could mark an important inflection point for the sector, and we expect to see some resiliency develop in these names relatively soon. Because the recent news has been largely anticipated, perhaps it is already priced into the stocks at this point.
The equal-weighted energy index is testing lateral support. The group remains on the offensive, and the price structure is marginally bullish at this time. Even so, the group has lagged the broader market on a relative basis. It has experienced enough weakness to generate an oversold signal in our 40-day SARSI indicator. Oversold signals in this indicator typically coincide with bullish inflection points as they measure an exhaustive move or when participants give up on a name and sell. With sellers out of the way, typically, little selling pressure remains. The oversold reading suggests looking for resiliency to develop off of this signal.
Currently, very little bullish traction exists in the sector. The divergence between crude oil and natural gas is one reason for the lack of interest in the group on the long side. Hydraulic fracturing has dramatically increased oil production the supply of natural gas as a byproduct of oil production. Global demand is high for crude oil, but while gas is consumed domestically, the flood of supply has nowhere to go. The net result is that companies that focus on crude oil should continue to do very well and natural gas names will continue to suffer and probably move lower.
West Texas Intermediate (WTI) crude broke out and confirmed a bullish head-and-shoulders consolidation pattern. The commodity has consolidated and digested gains, and we expect to see the upside price target of $125 reached. However, natural gas is still trying to find some equilibrium on the downside and remains locked in a downtrend.
The strength in oil and the current oversold condition creates an interesting and compelling case for the bulls. We believe this group will absorb the weakness in natural gas prices and regain its composure and bullish traction as crude oil prices continue higher. One way to play this developing opportunity is the SPDR S&P Oil & Gas Exploration & Production ETF (XOP). XOP is in the midst of a relatively orderly pullback to the support area at the $55 level, where it should find some renewed buying.
This group can have volatile moves, and the oversold reading does not mean there can't be further weakness. It does mean that the probability of a recovery rally is increasing and buying XOP near a support area makes this an attractive trade from a risk-reward standpoint. Use the current weakness, or additional weakness to the $55 level, as an opportunity to establish long exposure in XOP. The first upside target would be the $59-to-$60 range. Since this is an attempt to buy weakness, give XOP some room on the downside and use the $52.50-to-$53.00 range as a stop on long positions.