(06/11/15) Jim Stack Sticks with Energy

After dropping to lows not seen since 2009, the decline in crude oil prices is looking suspiciously like previous bottoms, suggests Jim Stack, editor of Investech Market Analyst.

In late January, the price of West Texas Intermediate (WTI) crude bounced off $44.08/barrel. It went back to test that low in mid-March, breaking to $43.39 before rebounding. For the past month, WTI oil has been hovering between $57 and $61.

While it’s still possible for crude oil to drop under the March low, history argues against it. The bottoming process was short in prior oil price declines, with only a brief and generally satisfactory retest of lows.

The exception was in 1998 when the initial June support was broken five months later; however, a remarkably strong recovery followed shortly thereafter. If the March support holds through August, it’s likely that the bottom in oil prices is in place…at least, for now, or until the next recession.

Historically, once a final bottom in the price of oil is in place, the ensuing rally can be impressive. The market can recover quickly, as it did in 1998 and 2007. At other times, including 1986 and 1994, it can take years for the price of oil to reach a new peak.

Looking at 2011, the price has yet to recover. In the current instance, it’s unlikely we’ll see oil above $100 (where it was last July) anytime soon, let alone above the $114/barrel peak in 2011…but that doesn’t preclude a substantial increase from here.

From an investment standpoint, energy stocks usually rebound along with oil prices. In past recoveries, the S&P 500 Energy sector averaged a 17.1% gain six months after oil prices bottomed, versus an average 8.0% gain in the S&P 500.

At 12 months after the low in oil, the sector index was up an average of 22.9% versus 13.9% for the broader market. Since the recent oil reversal on March 17, the energy sector is up about 4.5%, so there’s ample room for further recovery.

The rise in crude oil price from the March low is supported by shifting trends within the industry, despite a stubborn refusal by OPEC members to curtail production and help balance the market.

Reductions in exploration budgets this year by domestic firms are starting to have an impact. While there’s still a significant oversupply, drilling rig counts in the US have fallen by more than half since December.

The decline in active drilling sites is expected to begin reducing US production in the months ahead. Already, the US supply glut (noted in the headlines earlier) eased slightly more than expected in April.

With the US now acting as swing producer, projections for a narrowing of the global supply-demand imbalance in the second half of the year appear to be on track.

The energy sector has historically been a top performer in the final stages of a bull market, so we definitely want to maintain our current allocation and may increase it in the coming weeks depending on trends in that sector.

For those who invest in stocks, this may be a good time to look for energy ideas to potentially add to your portfolio. We suggest sticking with quality exploration and production or integrated oil companies.

Unless you’re looking for excitement, steer clear of the more volatile drillers, service companies, and smaller oil firms.

The bottom in crude oil may be in place but, as we’re in the seventh year of a bull market, proceeding with caution is the prudent course of action. If the global supply and demand gap does not resolve as expected, the low could be retested.

Also, the primary risks to watch for are bear market warning flags and/or signs of an imminent recession. If they emerge, it would definitely put a damper on any pending oil patch recovery.

As long as the bull market remains intact and we keep these cautionary notes in mind, the Energy sector should hold promise of near-term profits.

More importantly, it’s one of the few areas of the stock market where investors can still find value in today’s maturing economy. In our model fund portfolio, we continue to recommend a 10% weighting in the Energy Select Sector SPDR (XLE).