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Servicing Energy

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If the economy is going to rebound next year, then at some point demand for energy will return. There's a lot of supply to work through in the energy space, but a pick-up in demand as a result of an increase in economic activity should offset the overcapacity that was created in the past year. Most sectors of the economy have begun to discount an economic rebound next year. The financials, industrials, and techs have recently reflected a rebound. But the energy group has yet to discount a return of demand. Maybe there's more at play...

I define the energy sector by the Natural Gas Index (XNG), the Oil Index (OIX), and the Oil Service Index (OSX). The three are closely tied to the price of crude oil. They track one another closely. My "servicing" of the Oil Service sector in this update can be applied to all three, although there are a few minor differences unique to each sector. The Oil Service group seems to be leading to the upside and may serve as a better proxy for the group.

The energy sector is in an interesting place. It's working through overcapacity from the most recent build out and contending with an economic recession. To confound matters, the global oil players are duking it out in the crude oil market. The oil cartel known as OPEC recently proposed a production cut in an attempt to stabilize the price of oil. But Russia, a non-OPEC member, said it would not conform to the production cut. That was a few weeks ago. Fast forward to today and Russia is talking about a production cut.

In addition to the prospects of a Russian production cut, renewed violence in the Middle East has the price of oil moving higher today. I'd rather not write about violence and its impact on the financial markets. But such is the dynamic in the oil market.

The Russian rhetoric and Middle East violence pushed the price of oil back above the psychological $20 per barrel mark. If Russia does in fact cut production by 500,000 barrels per day, the energy sector could be in for a sustained move to the upside. But if Russia does not comply, there could be some serious downside in store for energy stocks. That's because OPEC said it would not cut production unless the non-OPEC producers (Read: Russia) did the same. The last thing the energy sector "needs" is a price war because price wars tend to be bad for manufacturers of the good/product/commodity. Price wars, however, are good for the consumers of the good/product/commodity. Russian energy officials are expected to decide on the production cut at a December 10 meeting.

The OSX is reflecting that Russia will adhere to the production cuts. It's higher today by about 2 percent, and attempted to advance past the 80 level earlier this morning. Further advancement in the OSX from current levels will place it near an intermediate-term descending trend that has been in place since June. The descending trend isn't as obvious on the bar chart, but is painfully obvious on the point & figure chart. Here's a shorter-term view of the OSX:

At this point in the trend, an advance past the 83 level would break the descending trend. I think such an advance would indicate that Russia will comply with the proposed production cuts and that the price of crude oil will rally over the short-term. An advance past 83 might also indicate that demand is returning to the group.

There may be a short-term trade to the upside in the OSX if it does breakout above its descending trend. Whether or not the fundamentals support a move in the short-term, there may be a quick round of short covering on an advance past 83. The fundamentals may very well support a much bigger advance, but the mechanics are in place for a short-term trade to the upside. If the OSX continues advancing at the pace it is today, then a breakout attempt could occur in the next two or three days.

Some of the stronger components of the OSX include: Baker Hughes (NYSE:BHI), BJ Services (NYSE:BJS), Schlumberger (NYSE:SLB), and Noble Drilling (NYSE:NE).

The one thing I greatly dislike about trading the energy group is the geopolitical risk involved. OPEC can be a fickle bunch. There's certainly risk involved every time you endeavor in the oil patch. But a solid advance in the OSX past 83 may mark the beginning of a longer-term trend and subsequent rebound in demand. It's something to watch, that's for sure, because the OSX would help to confirm the magnitude of the looming economic recovery.

Eric Utley
Option Investor

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