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Is Oil Greased to Rally?


Crude, energy sector show where the market's headed.

Back in July 2008, the financial media was attributing literally every intraday price move, in just about every US financial market that you could think of, to crude oil prices. Since then, crude oil has lost 76% of its value, declining from $160 per barrel to just under $40 last month, while all but dropping completely off the media's radar screen. Even though crude oil isn't as sexy at $48 as it was at $160, our work indicates that it's still just as economically significant.

The following is an excerpt from today's commentary that discusses the potential influence of the energy sector on both the direction of the US stock market and the US dollar due to energy prices' value as an indication of both economic demand and inflationary pressures.

Investor Sentiment Supports a Rebound in Energy

This set of charts, which display measures of investor sentiment pertaining to energy-related assets, indicate ideal conditions for recent strength in this sector to continue.
The first one displays the XLE in the upper panel, and my firm's Rydex Energy Ratio in the lower panel.

The Rydex Energy Ratio is the total assets invested in the Rydex Energy plus Energy Services Funds divided by the total assets invested in all 18 Rydex sector funds. It indicates how much "sector bet money" is being directed toward Energy by the investors in these ETFs.

Click to enlarge

The green highlights point out that the energy sector is currently at a multi-year under-invested extreme, once which has previously coincided with arguably the most important bottoms in the XLE (along with coincident extremes in relative sector underperformance, not shown) since 2004.

Accordingly, even though the energy sector has already outperformed the broad market by 19% since October, these data indicate that conditions remain ideal for further relative outperformance, plus outright strength in the XLE, over the next 1 to several months.

This next chart compares the percentage of assets invested in the Energy Sector to those invested in the other 8 Select Sector SPDR ETFs, by sector. To accomplish this, I sorted the 18 Rydex Sector Funds according to each of the 9 Select Sector SPDR ETFs that they pertain to, and then constructed a pie chart to indicate what percentage of the daily total assets invested in all 18 of these funds is being allocated to each individual sector.

Click to enlarge

The chart shows that, through the end of last week, 20% of all sector bet-related assets were invested in the energy sector. What the chart doesn't show is that the last time that the percentage of assets invested in Energy was this low was at the end of Q3 2006 -- which closely preceded the January 2007 major bottom in crude oil prices. The NYMEX contract then rose by $95 per barrel (139%) by July 2008.

We also note that the intermediary high in the percentage of assets invested in the Energy Sector was 40% at the end of Q2 2008 -- which immediately led the July 2008 major top in crude oil.

Accordingly, the data represented in this chart tells us 2 things:

1. The energy sector is under-invested enough, compared to the other sectors of the market, to help trigger another rally in oil prices that could be similar in importance to the one that began in January 2007.

2. The percentage of assets invested in the energy sector can essentially double from where it is now before we can expect another major peak in the price of oil.
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No positions in stocks mentioned.

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