Energy sector awaits risk rebound
There has been a lot of talk over the past two years about “risk-on” versus “riskoff ” trades, terms that generalize the overall investor appetite for taking risk. Of late, there’s no doubt been a rebound in investor risktaking, but it has been very selective, with some markets and sectors benefiting more than others. For example, investors have been buying U.S. equities and crude oil, but selling emerging markets and oil stocks.
The U.S. stock market has been a primary beneficiary. The S&P 500 has rebounded to within 12% of its record high in October 2007, recovering all of its loses from the 2008 financial crisis.
By contrast, the emerging market Shanghai index is trading at April 2009 levels and remains a whopping 61% below its October 2007 high, and the resource-heavy S&P/ TSX composite index is trading at September 2010 levels and is still nearly 20% off its record high in June 2008.
The S&P/TSX would have been a lot stronger if not for the Canadian energy sector, given its large weighting in the index. We find it rather perplexing that the capped energy index, which is heavily composed of oil-weighted producers, is currently trading near its May 2009 lows. WTI oil prices have in the meantime recovered all of their losses and are trading back at September 2008 levels, as if the global economy is in full-growth mode — something that just doesn’t make sense.
Consequently, the ratio of capped energy index to crude oil has collapsed and is trading at record-setting lows, levels not seen since the financial crisis.
Interestingly, the Canadian oil-and-gas sector has been trading at a 91% correlation with the Shanghai index since the beginning of 2011, up noticeably from its long-term historical 55% correlation. This tells us that investors have grouped energy with emerging markets and are avoiding both while playing the “safer” trade, which at the moment appears to be U.S. equities. This includes large U.S. technology stocks such as Apple Inc. that have been on a tear recently setting new record highs.
Looking ahead, there are two possible outcomes, in our view. First, should the “riskon” trade continue, it will move down to the perceived riskier sectors such as emerging markets and Canadian energy stocks. This is likely predicated on the European debt crisis being resolved or at least put down for a nap, as well as signs that the broader global economy can hold its own and resume a reasonable growth profile in the absence of central bank stimulus. So far, this doesn’t appear to be the case: European GDP is contracting while Chinese manufacturing growth has been moderating.
The second scenario involves a pickup in volatility over concerns of a European recession and defaults by Greece, Spain and Portugal. Then we’re back to a “riskoff ” market, and even the perceived safer trades such as U.S. stocks would unwind. That said, we would anticipate further central bank action in the U.S. or even China should this scenario play out — essentially putting a floor in the market.
All this considered, the best way to play both of these scenarios is through Canadian oil and gas. The sector has been decimated and many high-quality, long-life reserve oil companies are trading as if we’re in another global financial meltdown. There is even a great way to hedge this trade by shorting WTI crude oil prices through ETFS such as the HBP NYMEX Crude Oil Inverse ETF ( HIO/TSX).