As the price of West Texas Intermediate crude oil hit the skids on Monday, it was no surprise to see energy stocks contributing the most to the S&P/TSX Composite index's 360-point loss, its worst one-day performance since April 2013.
This relationship between natural resource equities and their respective underlying commodities seems obvious, and certainly holds over the long term. However, investors should be mindful of periods in which the gyrations of Canadian-listed energy stocks become meaningfully divorced from those of crude oil, as they tend to mark possible inflection points at which prices proceed to realign in an abrupt manner.
In mid-December, any sign of bottom-forming in crude was greeted with an abundance of buying in the energy space. The typical intraday price action would see the S&P/TSX Capped Energy index spike in the morning, and then slowly fade throughout the afternoon while remaining in positive territory on the session. These gains added up: from Dec. 15 until the start of this week's trading, the S&P/TSX Capped Energy index surged by 18 per cent while WTI had slipped by 5.8 per cent.
There's no iron-clad law that says movements in energy stocks must mirror the movements of the underlying commodity; far from it. For one, some companies have hedged a portion of their 2015 production at a significant premium to the current spot price, which will keep the drop-off in crude from pummelling their short-term, top-line figures.
But this striking divergence is worth highlighting, as it is eerily similar to disparities in the energy space seen over the past year. This isn't just a movie we've seen before – it's a rerun, playing on repeat.
In the middle of the summer, hedge funds continued to raise their bullish bets on crude even as the price began to soften. This contributed to oil's rapid decline in price, as the funds unwound those positions in the face of prolonged weakness. As well, the end of August and late November marked the beginning of periods in which energy stocks plummeted after trending upwards or treading water while the underlying commodity declined.
Scott Barlow, the Globe's market strategist, has done an admirable job demonstrating that cash flow estimates in this sector are predicated on substantially higher prices than we're seeing at the present moment. When the equity market is pricing in a higher level for crude oil than the commodity market is, that's not an optimal time to put money to work in the space.
Monday brought about a reversal of the recent trend, as energy stocks underperformed crude by roughly two percentage points. Admittedly, one day does not a trend make, but this session may herald the start of another stretch in which equity prices adjust in order to better reflect the increasingly entrenched low-oil reality.
A wave of downward revisions from analysts – one that washes away any remnants of excess optimism and prompts a flurry of selling – would serve as a better entry point for investors to begin adding to their holdings in this space, absent a rebound in the price of the underlying commodity.
SOURCE: Luke Kawa/Bloomberg