Head Fakes, Oil Inventories and Hedges

The latest head-fake rally in energy stocks and crude-oil prices appears to have run its course, with short covering among hedge funds and large traders petering out.

As we’ve asserted repeatedly, the near-term outlook for West Texas Intermediate (WTI) crude oil looks decidedly negative, with US crude-oil inventories exceeding their five-year average by about 30 percent and an intensive turnaround season for refiners around the corner.

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Although US onshore oil production appears to have rolled over, this correction won’t occur fast enough to alleviate the near-term glut. We maintain our long-standing projection that WTI prices could slip into the $30s per share in early 2016.

Meanwhile, as we explained in US Natural Gas: Outlook and Investment Guide, glutted natural-gas inventories and the potential for an unusually warm winter—thanks, El Nino—suggest that US natural-gas prices could plumb new lows in coming months.

The potential for further near-term downside in oil and gas prices will weigh on shares of exploration and production companies, especially when you factor in expiring hedges and shrinking output for some names. (See The Upstream Cash Flow Crunch.)

The near-term outlook for many midstream master limited partnerships (MLP) also looks challenging, with reduced drilling activity resulting in lower throughput volumes and fewer growth opportunities. Counterparty risk is another concern. (See The Risks as We See Them and MLPs to Avoid.)

Against this backdrop, investors who haven’t done so already should consider taking advantage of this opportunity to establish positions in ProShares UltraShort Oil & Gas (NYSE: DUG), which trades below our buy target after the recent rally.

As for the other hedges we highlighted in Buy the Friendly Skies, The Demand Side Beckons and Revisiting Our Hedges and Best Buys, we remain concerned about narrowing market leadership and other technical indicators that point toward an increased risk of a severe correction in US equities. (See Anatomy of a Market Top.)

In fact, if you exclude a handful of high-flying tech megacaps like Facebook (NSDQ: FB), Google (NSDQ: GOOG) and Amazon.com (NSDQ: AMZN), the S&P 500’s most recent rally didn’t happen.

The next issue of Energy & Income Advisor will include our latest take on all these hedges.

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Despite all this negativity, we remain bullish on 15 stocks that have what it takes to weather the storm and would consider establishing or adding to positions in these names at “dream prices”–levels that consider previous trough valuations during the 1980s and our outlook for commodity prices. (See Those Who Misinterpret the Past Are Doomed Not to Profit.)

Although many names in the energy sector face a winter of discontent, disciplined investors can take advantage of what could be an epic buying opportunity in select names–do not misconstrue this as a call to pile indiscriminately into energy stocks.