A glitch in the energy matrix?Something weird is bubbling in the energy space.
Before we delve in, let us briefly explain what the S&P Energy Select Sector Index represents. Some of you might already be familiar with XLE, the ETF which tracks the S&P Energy Select Sector Index (IXE). This Index seeks to represent the Energy sector by aggregating a basket of names in the sector.
A breakdown of the top 10 Index components shows the Oil & Gas majors taking up roughly 75.41% of the Index, and 91% of the total Index component being Oil & Gas exposure, while the other 9% being energy-related equipment and services.
CME E-mini S&P Select Sector Futures, XAE, tracks the aforementioned energy index, with the added benefit of margin offset and deep liquidity.
Now given that the S&P Energy Select Sector Index is made up of mostly big Oil & Gas names, we would expect some correlation between the prices of oil and the Index itself.
A look at both from the depths of the low in March 2020 till now shows both products moving closely together up until recently, where zooming in we see…
the glitch in the matrix.... The 2 have been trading generally in lockstep since the bottom in 2020, but have diverged in a peculiar fashion, since the middle of July, with the energy sector gaining roughly 28% since, while Oil tumbles close to 30%!
Has the exuberance in energy stocks been overdone?
In our opinion yes and we see a couple of headwinds for the Energy Sector in general:
1) The impressive rally from the depths of COVID has been driven by rising oil prices and share buybacks. Oil prices are now faltering, and tightening Financial conditions/Recession could slow or stop buybacks.
2) Political pressure to apply a ‘windfall tax’ on oil and gas companies could eat into energy companies’ earnings.
3) Stabilized tension from the Russian-Ukraine means lower uncertainty and pressure on oil prices, as supply and demand find equilibrium from alternative sources.
4) China’s continued zero COVID policy means low demand from the world’s largest importer.
From a price action perspective, XAE is trading just slightly off the all-time high range, which could prove to be an area of resistance.
All things considered, we think this presents an opportunity to trade this divergence either by;
1) Shorting the XAE outright, which means to take a directional view on the Energy Index. A riskier trade.
2) Pair the XAE with the Crude Oil contract, by shorting the XAE and taking a long on the Crude Oil contract. A more risk-controlled approach.
Crude Oil Trades at a contract unit of 1000 barrels and the E-mini Energy Select Sector trades $100 x S&P Energy Select Sector Index. Each Index point is 100$ on the CME E-Mini Energy Select Sector Futures contract (XAE) and $1000 on the Crude Oil Futures. One way to construct this spread could be to calculate the contract value difference between the 2 products;
Spread = 100 x XAE1! – 1000 x CL1!
You can construct the chart on TradingView by typing the above into the product search bar.
This will show the Chart of the spread between the 2 products, which is close to the all-time high now.
As such we will lean on the short side of this spread, given the outperformance of the Energy Index relative to Crude Oil. We will also keep an eye on the upcoming OPEC meeting on December 4th to gauge the path forward for Oil Prices.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Sources:
www.cmegroup.com
www.cmegroup.com
www.cmegroup.com
www.ssga.com
oilprice.com
