Calling the turn in the price of Oil and the Energy sector has been on the top of every sell side's agenda as the career move. For the past three months, we have seen various houses talk about the Value over Growth trade. It is easy to do so and show mouth-watering charts that show the widest divergence. But as the last three months have shown, that spread grew even wider. Anyone who got long that trade in July or August, would have been burnt even more. It is not about the call, we all know Energy is cheap relative to Technology, but it is about timing that call. Or alternatively, if you do not have capital limitations and VAR drawdowns to worry about, sure you could be right over the next year but wrong 30% in the short term. Are you like Warren Buffet? Can you really hold on that long with that much pain?
It is strange that fund managers are obsessed with relative trades, the violent rotation out of Technology into Energy and vice versa. From a macro point of view, yes one could assume the pick-up in yields and all the talk of fiscal stimulus warrant a rally in "cyclical" assets and Commodities geared to the economy. That is top down view. But one cannot trade Commodities from a purely top down approach, the bottom up physical commodity market balances has to match too. Copper is a great example. It has been rallying since August as U.S. bond yields started moving higher, and was the perfect cyclical commodity to play the recovery trade. But Oil did not move until this past week. Why is that? It all boils down to demand vs. supply inventory balance. The Copper market is very tight. The Oil market suffered with too much oil. End of the day, macro can say whatever it wants, that is only a small nudge, the bottoms up inventory balances need to comply as well.
In March, when the coronavirus hit, we were at peak Oil demand, so obviously lockdowns were viewed as a ground zero halt to oil travel and consumption demand. The world went to zero, and so of course there was too much oil in a very short period of time, hence prices went all the way to sub-zero. But today, we are already at a low oil demand base, and it has been one of the reasons why Oil has not been able to rally, as jet fuel demand remains still muted. But coming from a low base as we enter winter heating demand period, Q4 is seasonally strong, it means that the impact of lockdowns is a lot less. So, waking up this morning to see more EU states announce lockdowns, saw Oil prices down 3% only to be up 3% on the day!
Oil demand has been picking up over the past four weeks, and excess inventories are declining. It is a small start, but a step in the right direction. Not to forget OPEC+ has every intention of keeping those 2.2 mbpd out of the market for as long as possible to get the price spike they want or rather need. But also keep an eye on India and Chinese demand that is showing a strong demand pick up despite the rise in virus cases. Distillate inventories are making a move in the right direction - they are falling - and that is why Oil prices seem to have found a floor for now.
If the U.S. goes into full lockdown, that is a different matter, as that will be very political. But for now, as things stand, Oil, for the first time this year, presents an attractive risk reward proposition. Inventories are playing ball too. Oil Equities have massively underperformed the Oil price, and so there is better value in Equities here. But be careful which ones you choose. Everyone likes to buy Oil majors, sure they can rally too, but they never really capture the upside and lose more on the downside.
This is why Technology has been underperforming since last week. But being long Oil stocks, does that mean you cannot be long Technology as well? These stocks are still giving you 35%+ EPS growth. Oil has remained cheap all year because the Oil price did not play ball. Now that we have a trigger, perhaps now is the time to look at "value".
