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It was a hard day for holders of the iShares U.S. Energy ETF (IYE). With shares falling by over 3%, the 1-month return for holders now stands at -10%. Unfortunately, for investors in IYE, I believe the bear market is just beginning, and there’s much more downside ahead.
The Instrument
IYE is an instrument which seeks to give exposure to companies that produce and distribute oil and gas. Holdings include 66 companies across the energy value chain with the predominate weighting being that of oil and gas exploration and production. This core weighting of IYE is precisely why shares have languished this month.
Over the last month, we have seen crude oil pricing decline as the market began assessing a potential oversupply situation in the weekly EIA data. The basic issue is this: inventories are climbing at a time of the year in when they typically should be falling. This climb can be seen in the 5-year range chart of weekly crude inventories.
The underlying issue and why crude inventories are climbing is that production continues to climb, and refining demand has not picked up.
What is particularly worrisome for holders of IYE is this: if crude demand does not pick up, and if inventories do not begin to fall, the price of crude oil is going to continue to drop. Today’s strong sell-off in crude oil officially broke the bullish trend which has been in place since the beginning of this year in glorious fashion.
Prior to today, price had been holding support in a pullback in an established bull market. Traders found support at prior resistance (established in late March), and market action appeared to be making a run to new highs. The current technical landscape is very clear: sell, and sell short crude oil in that today is the first day of a new downtrend.
This bodes poorly for the companies which constitute IYE’s holdings in that the primary market-cap weighted line of business directly benefits from the outright price of crude oil. Since a new downtrend has started in price, we are likely to see lower prices for the companies involved in exploration and production and, therefore, lower prices for shares of IYE.
Fundamentally, a bearish thesis began emerging in the data two weeks ago. Specifically, prices began falling at a time in which inventory growth started to outpace 5-year range inventory growth. Here is this relationship in graphical format.
This chart shows three things: the 2-month change in crude stocks, the 2-month change in the seasonally-adjusted 5-year average of crude stocks, and the difference between these two numbers. This chart is incredibly useful in that it gives an effective fundamental trading signal for timing price movements in the flat price of crude oil.
You see, when crude inventories grow at a faster pace than historic averages, it means that we are likely in an oversupply situation and prices drop. And, the converse situation in which inventories fall faster than average is correlated with price gains. Within the last month, this indicator has switched from the bullish status we were in since February into bearishness, as seen in the following chart which takes the above data and makes it a simple bullish/bearish indicator.
The last time this indicator switched into bearishness, the price of crude proceeded to fall by over $10/bbl, and the shares of IYE fell by over 20%. In other words, when this switch is made and the market becomes more oversupplied versus historical averages, bad things tend to happen to shareholders in the energy sector.
This indicator is flashing a warning sign to whoever is listening: energy has likely just started another downtrend which will potentially take several weeks or months to resolve. During this trend, we are likely to see crude stocks continue to move contrary to the 5-year average and the price of crude oil to fall, depressing share prices in IYE.
A Lifeline
There is one potential savior in this situation, and that is if refining demand is able to increase in the coming months. The demand side of the equation in the crude balances has been very lopsided for several weeks in that demand has simply not shown up. As previously discussed, refining runs have been pitiful for this time of year. However, there is an immediate catalyst that suggests that runs should be increasing in the near future: product stocks. As seen in the following two charts, gasoline and distillate stocks have been in the territory of undersupply for several weeks.
If refiners were to increase throughput to build stocks and resupply the product markets, then we will likely see crude draw and crude prices rally, which will pull up the shares of IYE. However, as you can see in the gasoline chart, refining doesn’t have to be the source for barrels if we continue to see such strong imports.
The refining market remains the only hope for domestic energy markets and the shares of the companies in IYE. Unless we see a slowdown in production growth (which is highly unlikely according to the EIA), then crude stocks are going to continue building, and the share price of IYE is going to continue to fall.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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