Think Oil Has Already Bottomed? Think Again

Oil and gas shares suggest the recent rally in the price oil could be a head-fake. Image source: The Motley Fool.

The oil-stocks correlation is back in force on Friday, as U.S. stocks traded at nine-week highs, ostensibly on a sanguine report from the International Energy Agency (IEA) which ventures that "[oil] prices might have bottomed." The S&P 500 (SNPINDEX: ^GSPC) and the Dow Jones Industrial Average (DJINDICES: ^DJI) (DJINDICES: $INDU) are up 1.32% and 1.10%, respectively, at 2:30 p.m. ET. Energy is the best-performing sector in the S&P 500, with the Energy Select SPDR Fund ETF up 2.48%.

The IEA's Oil Market Report for March, published this morning, is providing hope and excitement for oil bulls and the battered oil and gas industry. Although the report cautions that the strong rally in oil prices since mid-January "should not be taken as a definitive sign that the worst is necessarily over," it sees "signs that prices might have bottomed out".

However, Goldman Sachs, arguably the most closely followed investment bank in the commodity markets, isn't impressed. In a note out this morning, the Commodities Research team argues that the rally in prices may be "premature":

Sustained low prices are necessary in our view to maintain a sufficient level of financial stress [to finish a rebalancing that has only just started] ... An early rally in prices... would prove self-defeating.

Goldman's equity team echoes that view in a separate report also published this morning ("Rocky road to new oil order recovery: signs of clearing in the distance"), writing that "[o]il prices still need to remain sufficiently low so producers do not change their current capex [capital expenditures] and production trajectory."

Certainly, there are no signs that the recent improvement in oil prices has prompted exploration and production companies to review the deep cuts made to their capital investments.

Just this week, the No. 2 U.S. oil company, Chevron, announced that it is further reducing its capital and exploration spending for 2017 and 2018 to $17 billion and $22 billion per year, down from $20 billion to $24 billion.

The equity markets are forward-looking, so this columnist would expect the bottom in oil and gas shares to precede that for the price of oil. However, if we assume that oil did bottom in January, then it did so on the very same day as the top oil and gas stocks (Jan. 20).

That simultaneity would be inconsistent with recent historical experience. The following table shows that in the last two major oil market lows, oil and gas equities did indeed put their low in before oil:

Data source: Author's calculations, based on data from Bloomberg and FRED.

It's a small sample, for sure, but it suggests that the market bottom in oil is at least a couple of months away (assuming Jan. 20 was the bottom in energy sector stocks, of course). Goldman may be onto something here: The rally in oil prices could well be suspect, with today's price action based more on sentiment than underlying market fundamentals -- much like Monday's 20% surge in the price of iron.