Crude Oil, Equities Heading for Divorce: Searching for Alpha for February 2011

Why the energy sector is holding a weaker hand these days

It seems like everyone is rooting for the economy these days—even OPEC.

The Organization of Petroleum Exporting Countries announced last week that it believes that crude oil is too costly and unaccommodating to world economic growth.  As a result, the cartel plans to raise production in order to keep costs in check.  What at first may seem like a munificent gesture is obviously an attempt to increase the long-term demand for crude oil. But markets do not always follow supply-demand dynamics, as the news was countered by violence in Egypt, which resulted in a huge rally in the energy sector last Friday. 

That made January 28th an unusual day. Prices of crude oil and stocks have risen in lockstep for some time, which has resulted in a near-perfect correlation between the two.  And it’s likely that we are we finally facing a longer-term decoupling of these two markets. 

The reasons for this all lie in the fundamentals.  Stock prices are rising, in our view, due to the strength in earnings (109 of the 147 S&P 500 companies that have reported beat earnings estimates); strong M&A activity; and persistently low interest rates.  Meanwhile, the energy sector is merely riding on the back of a recovering economy.  Inventories of both gasoline and crude are rising, and if production is increased by OPEC, price pressure should be additionally curtailed. 

And let’s face it—at $90 a barrel, investors will eventually become skittish about inflation, which would serve to suck money out of equities and into commodities. Eventually, one of these two markets will prevail. Based on the fundamentals, the energy sector is holding the weaker hand.

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