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The Big Short Squeeze

Conventional wisdom has been growing stronger that oil and gas companies face a difficult 2016. As a result, last month short interest in the energy sector reached the highest levels in more than a decade — just as oil prices began to stage a mini-rally from the bottom.

The short-term outlook for oil and gas is still bearish given high inventory levels, but investors have started to look beyond the immediate glut. If you haven’t been watching closely, as I write this the price of West Texas Intermediate crude is up nearly 45% since bottoming out at $26.19 per barrel a month ago.

Energy stocks continued an 18-month decline as WTI slipped below $30, and at first failed to respond as oil prices began to move higher. The growing short interest may have played a part. But the disconnect had to come to an end. For a number of stocks, that began to happen last week.

A month ago energy was the most heavily-shorted sector in the S&P 500, and the six most heavily-shorted energy stocks were Chesapeake Energy (NYSE: CHK), Transocean (NYSE: RIG), Southwestern Energy (NYSE: SWN), Diamond Offshore (NYSE: DO), Consol Energy (NYSE: CNX) and Helmerich & Payne (NYSE: HP). Each of these had short interest above 20% of shares outstanding.

Every one of these stocks surged in the second half of last week, with Chesapeake leading the way with a gain of 86% in just three days. The surge coincided with the death on Wednesday of Chesapeake founder and former CEO Aubrey McClendon, but the rally in the energy sector was broad-based.

In the MLP sector, more than 20 partnerships had weekly gains of more than 20%. Some of the biggest could be found in the long-suffering upstream sector and among related service companies, with Linn Energy’s (NASDAQ: LINE) share price more than doubling while Mid-Con Energy Partners (NASDAQ: MCEP) wasn’t far behind with a gain of 91%. Hydraulic fracturing sand provider Emerge Energy Services (NYSE: EMES) was up 60% on the week, while several others gained at least 50%.

The broader sector moved up as well, with the Alerian MLP Index rising more than 7% last week. This was one of the 10 best weekly performances ever for the index, the second time in three weeks the Alerian accomplished that. Since bottoming in February, the index is up nearly 30%, nearly matching the increase in the price of oil.

But before you rush to jump back into the sector, keep in mind that not a single one of the 20% plus gainers from last week has a positive return over the past 12 months. Nearly all of the upstream MLPs have trailing 12-month returns of -70% or worse, despite last week’s gains. Further, only about a third are in positive territory in 2016. On the other hand, this rally should shake out a number of the shorts that have helped push energy stocks down.

While it is impossible to consistently time market tops and bottoms, my strategy in this volatile environment is to accumulate shares as long as I feel that energy prices are below a sustainable level. I continue to believe that is the case. Join us at MLP Profits as we cover the partnerships best-placed to benefit from the inevitable recovery.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

 


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