A hot new trading idea did the rounds this week: the worst is over for US oil and gas stocks. Some people took it so seriously they went hunting for the ugliest oil stocks they could find, sparking a stunning rally in stocks of nearly bankrupt shale companies.
Shares in Chesapeake Energy, for example, which has been teetering on the brink of collapse, shot up about 400 per cent in a few days, before toppling again towards the end of the week.
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"Investors are just betting on recovery as a theme," said Nathan Anderson at Hindenburg Research. "The way they express that is by buying stocks that are the most down, hoping that they'll revert to their pre-Covid level."
Hope has also taken hold beyond the day traders on Robinhood and other free platforms. Since mid-March, in the bleak days after Saudi Arabia launched its war for market share, the S&P 500 Energy sub-index has risen by more than 60 per cent, beating the rest of the market.
But can the rally continue?
The near-universal answer, outside the Reddit stock picking forums, is no. If the top of the rally was not already reached with the Chesapeake rise this week, it is not far off.
True, things are not as bleak as they were. West Texas Intermediate, the US benchmark, is unlikely to fall below zero again soon, as it did briefly in April — although some shell-shocked traders will have winced as it dropped about 12 per cent in recent days. At about $35 a barrel, it remains almost double its level at the end of April.
Bulls note that Saudi Arabia and Russia extended their large oil-supply cuts just last week, while forecasters from the US government to Goldman Sachs now expect global oil demand to outpace supply in the second half of this year, as economies emerge from coronavirus lockdowns and people start moving. Exploration and production stocks beaten down by the crash, runs the thesis, now look attractive.
But hold on. Beaten down they may be, but stocks are still far from cheap. Muqsit Ashraf, of Accenture's Houston energy practice, estimates that at current prices, oil and gas shares assume oil at about $50 a barrel. That cannot last. And the equities are more likely to do the correcting than the commodity, he predicts.
Retail investors may be piling in but more sophisticated investors such as hedge funds want a retrenchment of 20 per cent to 30 per cent in the stock prices of E&P stocks before they start buying again, said Matt Portillo, an analyst at Tudor, Pickering, Holt & Co, an investment bank. "Most are focused on very few names and are very sensitive about their entry price points."
This is because the fundamentals of the oil market are less constructive than the bull case suggests.
Despite the Opec extension, Saudi supply is about to rise as the country ditches extra cuts it made in June. US production has fallen hard but is picking up. Refiners are inundated with petroleum products, so need less crude. US oil stockpiles hit a record high last week. Covid-19 cases are surging anew.
The glut, in other words, is far from over and the $45 to $50 price needed by most operators to turn a profit seems a long way off.
Meanwhile, the volatility in the market has delayed the mergers and acquisitions that almost all investors want to see across the shale patch.
So the rest of 2020 will be characterised more by insolvencies than M&A, thinks Mr Portillo, adding that buyers may go on the offensive only if prices stabilise well above $50 a barrel. Meantime, the lack of M&A will be a damper for equity prices.
Other clouds hang over the sector.
Investors remain jaded by their experience with the shale patch in recent years and want proof that operators will not start chasing volume and abandon pledges of operating within cash flows, said Jay Merchant, a portfolio manager at Invesco. "The moment they deviate, they will be punished," he said.
Meanwhile, Saudi Arabia's decision to open the taps in March — its oil is still arriving in the US, inflating crude stocks — has spooked many fund managers, who appreciate that the sector remains vulnerable to geopolitics from Riyadh to Washington.
Finally, there is oil's big-picture problem: even if the producers still believe in the future of their product, their investors are increasingly doubtful about oil, full stop.
All told, it is little wonder Wall Street is not yet rushing back to a US E&P sector struggling with existential doubts. Maybe the day traders got it right with their bust shale trade this week — in and out quickly, before things get even worse.
- Financial Times