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Energy Stocks Could Get Uglier, Say Analysts

Recent stock market weakness and a bearish 2010 U.S. natural gas outlook appear to be trumping improved energy fundamentals, and energy stocks "could get much uglier if the market malaise continues," Raymond James & Co. Inc. analysts said last week.

In periods of substantial market uncertainty and rapidly shifting fund flows, the broader markets tend to be more important energy stock price drivers than energy prices, wrote energy analysts J. Marshall Adkins and James M. Rollyson in a Stat of the Week.

"While U.S. natural gas prices will still ultimately be the most important drivers of E&P [exploration and production] and oilfield service fundamentals, the fact that oil prices have been recently moving with the stock market (and inversely with the U.S. dollar) only reinforces the energy stock to broader market linkage," they said.

The market has been acting differently in the past year than it had in the previous decade, noted the duo. They based their findings on data compiled by blending two energy indexes: the Philadelphia Stock Exchange Oil Service Sector (OSX) and the Standard & Poor's Exploration & Production (S&P E&P)1500 index.

"In the decade prior to the 2008 market meltdown, timing energy stock selections was fairly simple," said Adkins and Rollyson. "Figure out the direction of oil and gas prices and the energy stocks would follow. Most of the time, the 'gassy' stocks tracked with U.S. natural gas prices and the 'oily' stocks tracked with oil...The market's crash shattered all of these templates in 2009.

"As the broader market rallied from March throughout 2009, energy stocks rallied with the broader market and at almost twice the pace. Specifically, energy stocks...outperformed the broader markets (or the blended S&P E&P 1500 and the Dow Jones Industrial Average indexes). Specifically, the two energy indexes averaged up 86% from the bottom in March versus the broader market indices that rose 52% from the trough."

For the full year, 2009's "relative energy stock performance was even better, up 42% while the broader markets averaged up only 17%," said Adkins and Rollyson.

However, since January the uptick in the broader market has begun to falter, they noted. "Difficult economic news domestically and even more challenging economic news abroad has started to reverse the upward trend in stocks, the U.S. dollar and most commodities. As was the case during the 2009 rally, it appears that energy stocks are once again moving at a pace that is 1.5-2.0 times the rate of the broader market, only this time in the wrong direction."

Trends in the past year also suggest that energy stock movements "will be almost twice as volatile as the broader markets," the analysts noted. "Specifically, the major energy indexes...have moved roughly 70% (or 1.7 times) more than the broader markets over the past year. While this new relationship made energy investors happy in 2009, it has resulted in heartburn over the past month. If the broader market continues to deteriorate and the U.S. dollar continues to rally, it is likely that energy investors could be seeing red for a while."

Adkins and Rollyson noted that they didn't have any "special insight" into the near-term direction of the broader stock market. However, "energy stocks are likely to be a high-octane directional play for whichever direction that the market may move."

For now, said the duo, market participants may want to keep their "energy chips on the sideline...and wait for signs of a bearish market to fade."

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