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Risk On, Risk Off

By Elliott H. Gue on Feb. 4, 2016

Over the past week, the price of West Texas Intermediate (WTI) crude oil rallied to more than $33 per barrel from the Jan. 20 low of $26.19, dragging most energy equities along for the ride.

The financial infotainment industry attributed this upsurge to rumors that Russia and Saudi Arabia were discussing a coordinated production cut. This sensationalist claim doesn’t pass the sniff test when you consider Saudi Arabia’s commitment to retaining market share at a time when Iran has resumed exports.

In reality, much of the jump in crude-oil prices likely stems from short covering. According to data from the Commodity Futures Trading Commission, hedge funds increased their reported short positions in WTI futures contracts to a record 201 million barrels on Jan. 12 from about 56 million barrels in mid-June 2015.

(Click graph to enlarge.)hedge Fund Aggregate Reported SHort WTI

Given the magnitude of the move in WTI prices over this period, it was only a matter of time before hedge funds sought to turn some of these paper profits into real gains by buying futures contracts to cover their short positions. From Jan. 12 to Jan. 26, hedge funds covered about 23 million barrels’ worth of short positions—a trend that likely continued into the next week.

After the absolute shellacking that oil prices and most energy stocks suffered in the new year, this relief rally definitely lives up to its name. However, the fundamentals suggest that our outlook for crude-oil prices to suffer another whoosh down to between $20 and $25 per barrel remains intact.

Excluding the Strategic Petroleum Reserve, US crude-oil inventories remain about 23 percent above their average for the past five years; planned refinery outages for maintenance and upgrades, coupled with resilient US production, suggest that this supply overhang will only continue to grow over the next two months.

Accordingly, investors could have another chance to buy high-quality energy stocks at dream prices. The table below highlights some of our favorites, with the heart symbol denoting names that appear on our Focus List.

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