Friday, June 14, 2024
An Energy Market Play: Shorting XLE with a Long Position in WTI
تم إعداد هذا المنشور من قبل سنشري للاستشارات

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The Securities
The Trade involves 2 securities:
The NYMEX WTI Crude Oil futures (WTI): is the world’s most liquid crude oil contract. When traders need the current oil price, they check the WTI Crude Oil price. WTI (West Texas Intermediate, a US light sweet crude oil blend) futures provide direct crude oil exposure. This product is available on the Century Trader platform under the description “Crude Oil West Texas - Cash” and the Ticker “WTI_CASH”
Energy Select Sector SPDR Fund (XLE): The Fund seeks to track the energy companies in the S&P Index that primarily develop and produce crude oil and natural gas, and provide drilling and other energy-related services.
The Rationale
In the past 2 years, the price of crude oil has been on a downtrend, however, despite this the price of XLE has diverged and has been on an uptrend driven by the broader stock market strength in the US. However, currently given the declining industrial activity in the US, the depletion of built-up COVID savings, and a potential wipeout on credit capacity, a pullback in the price of XLE is expected, as both the sales price and the quantity of the energy companies are now expected to be impacted. Hence, the trade is based on the rationale of an anticipated drag in the earnings of the companies operating in the energy sector. Furthermore, in order to hedge the short position, a long position in WTI may be entered.
Ratio Analysis
The ratio between WTI & XLE
Source: Trading View
Date: 5th June 2024
From the above ratio chart, it can be witnessed that the ratio between WTI & XLE has been on a downtrend, and is near a major support level, around 0.7713 level, and given the current ratio at 0.8183, a major rise in the ratio can be expected.
Normalized 2-Year Price Chart Comparison of WTI & XLE
As mentioned earlier, from the below 2-year normalized price chart, it can be observed that there exists a divergent performance between the XLE and the WTI, with the XLE outperforming the WTI. Furthermore, it can be observed that the performance of the XLE has slightly lagged compared to that of the WTI. Hence, a further downturn in the price of XLE can be expected
Source: Trading View
Date: 5th June 2024
Note:
Blue Line: WTI
Black Line: XLE ETF
Short: Energy Select Sector SPDR Fund
Business Model Review of Energy Companies
With regard to Energy Companies a notable financial metric must be considered – Operating Leverage, which measures the degree to which a firm can increase operating income by increasing revenue.
From a business model perspective, Oil and gas companies tend to have high operating leverage, here's why:
- High Fixed Costs: Oil and gas exploration, development, and production involve significant upfront investments in infrastructure, rigs, and pipelines. These fixed costs are substantial and don't vary much with production levels in the short term
- Variable Costs: There are also variable costs associated with oil and gas production, such as labor,maintenance, and royalties. However, these tend to be a smaller portion of total costs compared to fixed costs.
Impact of Operating Leverage:
Profit Magnification: During periods of rising oil prices, a small increase in revenue can translate into a much larger increase in operating income due to the high fixed cost base.
Profit Volatility: Conversely, when oil prices fall, even a small decline in revenue can lead to a significant drop in operating income because the fixed costs remain high.
Hence in conclusion, high fixed cost structures make them sensitive to changes in oil prices, potentially leading to amplified profits or losses depending on the market environment.
The pullback in WTI Expectations
Recently, the price of WTI has been on a decline since the start of the year, and looking ahead the pressures are expected to continue to mount on the commodity.
On 2nd June 2024, OPEC+ decided to maintain 3.6 million barrels per day (bpd) of production cuts until the end of this year. However, the group will begin scaling back 2.2 million bpd of those cuts from the end of September 2024 through October 2025.
This tapering plan was seen as a bearish signal for the market, especially if demand does not materialize as OPEC+ has forecast for the coming year. It also indicated that the producer group has limited room to continue supporting oil prices.
Furthermore, Manufacturing in the US could also be seen to be weakening for a 2nd straight month in May, raising concerns of dampening economic activity in the world’s largest fuel consumer, potentially leading to weaker demand.
Long: WTI
Given that the Energy companies’ revenues are highly sensitive to oil prices. When oil prices fall, the earnings of these companies tend to decrease, leading to a drop in their stock prices. Conversely, if oil prices were to rise, the increased revenue could stabilize or even boost the stock prices of these energy companies, which would be detrimental to a short position in XLE. By taking a long position in WTI, you can potentially offset losses from an unexpected rise in oil prices.
Historically, there has been a 74.1% correlation between XLE ETF and WTI in the past 2 years.
2-Year Correlation Between XLE and WTI
Source: Bloomberg
Date: 5th June 2024
Note:
1. Total Return (%) * calculated assuming 2x leverage on $100,000, resulting in exposure of $200,000
2. Estimated Future Price (Hypothetical ) has been calculated using the historical average prices
3. Holding Cost and Dividends are not included in the return calculations
It is essential to note that Pair Trading is not a risk-free strategy. The diffculty comes when prices of the two securities move contrary to the positions taken, resulting in losses. Thus, adhering to strict risk management rules is vital when dealing with adverse situations.
Past performance is not indicative of and does not guarantee future results. Trading in markets may involve a loss of capital.
The return calculation does not include the holding cost paid on the strategy and this could change in the future, impacting the strategy either positively or negatively. The returns do not consider the currency depreciation of the Euro and US Dollar. Investors will have to hedge the currency exposure separately.
In instances of tail-event risk scenarios, it's conceivable for both Equities to experience simultaneous declines in value.