Although the drilling rig count has begun to drop sharply, oil production continues near record levels.  Eventually the reduced capital spent will lead to lower supplies but, for now, production remains near record levels suggesting that energy prices will not be heading to any sustainable higher level in the near term.

The oil stocks had fallen much more than the actual price of oil, particularly the smaller Canadian companies that have ‘stretched’ balance sheets.  Investors were concerned that they didn’t have the financial resources to survive the downturn.   But investors may have gotten a little too bearish. The chart below shows the short position (i.e. negative bets) in the energy sector.   They have risen to record levels.  While the next year will clearly be difficult for all energy companies, the Canadian companies have also seen a sharp fall in the value of the Canadian dollar, mitigating some of the losses.   While picking a bottom is always tough, the large short positions suggest much more volatility ahead.  Rallies will therefore be very sharp and we have seen such a rally in the past six weeks.

S&P 500 Energy Sector Short InterestWe added some names in January where the balance sheets are in relatively good shape (i.e. Raging River Exploration, Secure Energy Services) but are still under-weight the group.  Until we see oil production actually start to fall, it’s hard to see anything but short-term rallies in the group.   The beneficiaries are the companies that use oil as an input.  Airline stocks remain at the top of that list and it’s no surprise that they have been one of the best performers over the past six months.

Overall though we remain cautious on stocks.  Markets have not seen a 10% correction almost four years, investors are complacent about risk, earnings growth is slowing and perhaps going negative and the global economy continues to be in a deflationary spiral.  Central banks are pulling out all the stops but the ‘zero interest rate’ policies have just not been successful in doing anything but inflating the value of financial assets.  It’s a dangerous game they’re playing and stock market investors could suffer significant losses if these monetary ‘experiments’ don’t end up working.  Cash may not look like a great alternative right now, but it beats losing money if ‘things turn south’.  We will continue to monitor these developments very closely but remain unconvinced that there is not significant market risk right now.

1 2 3 4