How to trade the upside when energy turns

March 24, 2016 01:00 PM

Another failed rally by energy stocks in late January followed almost immediately by the Super Bowl made us wonder, what do energy stocks and the Buffalo Bills have in common? Namely that they both have all the pieces in place to make a decent showing for themselves and yet somehow find new ways to disappoint us.  

High short interest and implied volatility coupled with extremely negative sentiment (not to mention being cheap relative to their peers) usually makes for explosive moves higher when the news begins to turn, which proved to be the case when the chairman of Aramco announced that crude below $30 was “irrational.” However after just two short weeks the rally fizzled as prices fell back to their lows and sent us to study our fund flows data to find a reason why energy funds couldn’t achieve lift-off. 

Investors basically have two ways of investing in energy: Either through funds specializing in energy stocks and or in commodity funds offering more direct exposure to price shifts, but with higher volatility making them more suitable for tactical plays than long-term investments. For a rally that can go the distance, you’d like to see more money flowing into those equity energy funds; however, January’s big run-up in commodity prices left us with an almost 1:1 ratio between the two options. To make matters worse, the vast bulk of the new money that went to equity energy funds went to broad-based sector funds like the Energy Sector Select SPDR (XLE), giving them something like a 4% bump in assets, while smaller funds or those specializing in specific subsectors were still net losers. Spillover into energy-heavy natural resource funds also can be a useful indicator of a sustainable rally and was completely missing during January’s big move.         

If investors were being careful about putting money to work by buying bigger funds, there was no time for caution among traders who bought volatility looking for a quick return. Nearly every commodity ETF was showing a large inflow of new capital, most notably the United States Oil Fund (USO), whose assets jumped nearly 52% as the switch flipped from sell to buy.  And for the more nimble trader, it’s hard not to see the attraction of going long the most volatile parts of the energy complex, as USO returned 17.7% from the trough on Jan. 21 to the peak on Jan. 28, while XLE was up a mere 9.25%. But even that 17.7% move pales in comparison to some of the returns for the most beaten up MLP funds that have steadily underperformed the broader energy sector over the last year. Among the biggest winners was the InfraCap MLP ETF (AMZA), which was up more than 32% in just six days while simultaneously increasing its asset base by 30% after losing almost 46% in 2015. 

In fact, the only outlier to our volatility theme was the strong showing by energy funds offering exposure to international stocks including the iShares Global Energy ETF (IXC), which saw a 7% inflow despite almost the same volatility as XLE (see “Outlier”). What made IXC so attractive was that it offered exposure not just to less volatile large-cap names but to international stocks that could potentially benefit from improving sentiment and a falling dollar as investors begin to consider the ramifications if the Fed chooses to abruptly halt its plan to continue hiking rates later in 2016.  

While January’s rally may have been short-lived, it might have provided investors with a valuable playbook on signals to watch and how to position themselves for when a true floor is reached.   

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global