Black Gold: How to Carefully Trade the Oil Equities

By Joshua Enomoto, Founder of and Contributor
Thanks to fears from the fiscal cliff crisis and other pressing issues, Americans have enjoyed several months of relatively low gas prices. Of course, much of the savings depend largely on where you live, but even in tax anti-havens like California, the reductions in cost were both noticed and appreciated. Of course in this cabal-run industry, no good deed goes unpunished and we are, like clockwork, right back to where we started: egregious pain at the pump.

Other than riding a bicycle or revoking your “man-card” by purchasing a Prius, there’s not much that we could do directly to reduce our individual dependence on crude oil. However, there are a few indirect ways to hedge against rising prices and the most obvious method is to invest in major oil companies, such as Exxon-Mobil. What is not so obvious is the trading strategies needed to maximize profit: for instance, many people have a simplistic belief that crude will continue to rise perpetually higher and ironically end up adopting a “silver bug” mentality, otherwise known as “buying at any price.” While a lot of investment mistakes can be covered up in a high-demand commodity market via extension of time frame, opportunity costs cannot. Regardless of how bullish an asset may be, it always pays to get in at the lowest price possible.
One of the common misconceptions about investing in the oil sector is that as the price of crude goes up, so goes the oil company. While many times this is certainly the case, it does not always ring true. Consider the below 1-year daily chart of Exxon (XOM) and crude oil (WTI):
  XOM (02092013) A
From September to the final days of 2012, XOM and WTI were in fact inversely correlated with each other and those that dumped XOM prematurely based on weakness in crude made a regrettable mistake. Eerily, the decline in crude came off the announcement of QE3, suggesting that the Federal Reserve lacks the ability to manipulate the markets at will, and more importantly, that deflationary forces are in play. Mere inflationary fundamental drivers will not necessarily move crude higher, nor does it guarantee profitable trades in oil equities even if the underlying fundamentals are bullish. 
Now let’s consider the current technical picture of XOM: 
XOM (02092013) B
Based on a Fibonacci retracement analysis using the June 2012 bottom as the anchor and the following October high as the mast, XOM is postured bullishly as three re-tests of the 61.8% retracement level held firm. The technical indicators, such as the Moving Average Convergence-Divergence do suggest that current momentum may be fading a bit as the bulls and bears attempt to figure out which direction to take the stock. On the bullish side, the most obvious target is the $92/share price point (the October high), which would only represent a 3.8% move. The downside would be more pronounced as the $84 and $82 price points, represented by the 50% and 38% retracement levels , would be reasonable targets. At the lowest retracement, this would mean a decline of 5.2%, so the” risk:reward” ratio would only be 0.73, a not so favorable metric.  
There is another factor to consider and that would be the value of Exxon relative to spot-crude: when the XOM:WTI ratio becomes technically undersold, this usually signals a good buying opportunity, although it must be stressed that this is not always the case: 
XOM (02092013) C
The most obvious time frame when this “ratio signal” did not play out kindly was in late February 2012, when the XOM:WTI registered undersold in the RSI, only to see XOM decline by more than 10% by early June. However, if an investor held on, the stock eventually hit $92 for an 8.2% profit. Right now, the XOM:WTI ratio is near undersold status, suggesting a possible run up in Exxon as the busy summer season approaches.  
However, the decline in XOM last May coincided with an equally sharp drop in the US equities market. In fact, a similar phenomenon occurred in the summer of 2011 when XOM and the general stock market faded in lock-step. This means that XOM would be a buy ONLY if the S&P 500 were to move higher from here. Many in the alternative investment community, myself included, believe that the stock market is due for a correction: if so, such a deflationary action would likely take down both spot-crude and oil equities and any trade in this sector should be executed with a (very) short time-frame until that major decline occurs.