Oil Futures and the Equity markets

Last week’s article dealt with finding a good entry price for highly rated oil company stocks that appeared to be overpriced. The strategy was to identify a range then determine a value zone defined as 50% to 62% of the range. It basically identified areas that would be good to buy in the direction of the main trend. It’s a technique typically used by investors who are cautious about buying strength out of fear of buying a top.

The downside of this technique is that sometimes momentum takes over and the stock never reaches the value zone. Nonetheless, it is one strategy that should be kept in the toolbox of aggressive traders and more conservative investors. While waiting for a pull-back into a value-zone may be a valid strategy under certain trading conditions such as a strong uptrend, there are times when oil stocks are driven higher by other factors.

Oil company stocks are influenced by several factors. Simply stated, a portion of a strong rally is attributed to good earnings. Another portion just follows the broad-based market. Another part of the rally may be fueled by bullish fundamentals of an underlying commodity. When it comes to energy-related companies, for example, the price of oil often has a huge influence on a stock’s movement. However, not all oil companies move the same when oil prices spike higher. This makes sense because some oil companies deal with oil already in storage and others deal with it still in the ground.

Looking at a series of energy stocks, one can see the influence of the broad-based bull market on price movement also. These energy stocks are highly correlated with the stock market which means that they will ebb and flow as a stock index swings up and down throughout the course of the year. There are times, however, when the underlying commodity drives prices higher while the broad-based market weakens. This may be taking place in the markets at this time.

This week, August Crude Oil futures soared over 3.5% due to several bullish factors while the S&P 500 and Dow showed signs of a top. Believe it or not, the fundamental events that drove up oil futures also helped weaken the equity markets. Those investors who had portfolios more heavily weighted in oil company stocks however, did not see the same selling pressure as those who had portfolios that were more broad-based. This is because aggressive investors ignored the weakening stock indices and instead focused on surging oil prices.

The big jump in oil prices was triggered by several events including a firming trend in Asia, a bullish U.S. stockpiles report and rising concerns that turmoil in Iraq will disrupt Middle East supplies. The last event exerted the most influence because whenever supply disruptions make the headlines, aggressive speculators come in to drive prices higher. Not having oil tomorrow drives oil prices higher much faster than not having oil 6 months from now.

Looking at this week’s charts we see that as August Crude Oil futures soared and June E-mini S&P 500 Index futures declined. However, Exxon (XOM) investors decided that the company would benefit more from the rise in prices and the market rallied.

The decision for aggressive investors this week is whether to buy Exxon (XOM) in anticipation of a possible breakout over the 52-Week High at $103.45. This decision will be based on whether they believe crude oil prices will continue to move higher on speculation that the military action in Iraq will spill into the oil fields. If this is the case and supply is interrupted then look for Exxon stock to outperform the broad-based S&P 500 Index. This is a highly speculative short-term move that requires the investor to watch the fundamentals and crude oil futures prices.

Since Exxon has a substantial amount of oil in storage, selling it at market prices should yield a strong profit that will help increase earnings. This is the logic behind the trade, but its success depends on the price of oil continuing to rise on speculative buying.