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Getting Ready for a Real Buying Opportunity

By Elliott H. Gue on Sep. 26, 2015

Over the past two years, oil and gas producers have accounted for the bulk of the energy sector’s bankruptcies, laid low by excessive leverage, the collapse in commodity prices and inferior assets. Exploration and production companies haven’t emerged from the woods yet—but they’re not all goners. In fact, the buying opportunity that investors have awaited appears to be around the corner.

The Big Pullback

Our near-term outlook calls for further weakness in the price of West Texas Intermediate (WTI) crude oil, as US inventories remain 27.4 percent above their five-year average and summer driving season has ended.

Estimates from the Energy Information Administration’s latest drilling productivity report suggest that monthly US oil output has started to decline on a year-over-year basis in key basins.

(Click graph to enlarge.)
Oil production 4 shale plays

However, production remains at levels that will swell already elevated domestic stockpiles even further in coming months, a period when refiners historically have idled some of their capacity for maintenance and upgrades.

To worsen matters, management teams from Valero Energy Corp (NYSE: VLO) and other US refiners have warned that this turnaround season could involve more outages than in previous years because the industry ran flat out last summer to take advantage of robust crack spreads.

All these headwinds create the potential for WTI prices to suffer another leg down into the $30s per barrel later this year or in early 2015—an outlook we’ve held for much of the past 12 months.

As for WTI’s sharp rally to almost $50 per share at the end of August, data from the Commodity Futures Trading Commission suggest that this upsurge largely stemmed short covering on the part of hedge funds and other institutional investors. Profit taking on these trades has reduced the aggregate reported bets against WTI to about 105 million barrels from 163 million barrels in early August.

(Click graph to enlarge.)CFTC Short WTI

Additional short covering could fuel fleeting rallies in oil prices in coming weeks. But hedge funds and other large traders have been loath to establish long positions—a sign the market lacks conviction that WTI prices can mount a sustainable rally in the near term.

We also lack conviction in any near-term upside oil prices and see the potential for another leg lower in coming months—one reason why cheap energy stocks likely will get even cheaper.

For this reason, we’ve encouraged readers to keep some powder dry and consider establishing a position in our favorite hedge: ProShares UltraShort Oil & Gas (NYSE: DUG), and exchange-traded fund designed to deliver twice the inverse of the Dow Jones US Oil & Gas Index’s daily return. ProShares UltraShort Oil & Gas rates a buy on pullbacks to less than $75 per share.

At this juncture, Royal Caribbean Cruises (NYSE: RCL) and Casey’s General Stores (NSDQ: CASY) trade above our buy targets; in this volatile market, investors may want to consider taking some of their profits off the table. American Airlines (NSDQ: AAL), however, has yet to surpass our buy target of $50 per share.

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