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Profit From the Turning Tide

The stock market is experiencing the second longest streak on record without a 20% drop in the S&P 500. This streak began after the previous bull market ended in a sharp crash. 

Between October 2007 and March 2009, the S&P 500 dropped by 56%. By the time that bear market ended, the index was at levels last seen in 1997. 

Naturally, you want to avoid that fate within your portfolio, but at the same time, you don’t want to be on the sidelines as long as the bull market continues. 

You could start buying some put options as insurance against a significant drop, but another strategy is to start rotating money into a sector that appears to be emerging from its bear market. 

I speak, of course, of the energy sector, which entered a bear market in the second half of 2014. 

Although the energy sector rebounded last year, the fundamentals behind the bear market hadn’t changed substantially. So, the gains in 2016 were mostly given back in the first half of 2017.

But now, for the first time in three years, both the market fundamentals and sentiment have begun to change in earnest. Over the past couple of months, I have noticed a marked shift in the tone of the business press and among analysts over the energy sector.

The reason for that can be found in the highlights from the International Energy Agency’s (IEA) most recent Oil Market Report.

The report notes that global oil demand grew by 2.3 million barrels per day (BPD) year-over-year (YOY) in Q2, which was a stronger-than-expected pace. The IEA revised the 2017 growth estimate for 2017 upward to 1.6 million BPD. Demand growth has been unexpectedly high in Europe and the U.S., driven by low oil prices.

But crude oil demand grew strongly throughout the current energy bear market, so that alone isn’t enough to signal that better times are ahead. 

Where things get interesting is in the global supply picture.

In August, oil production fell in both OPEC and non-OPEC countries. Global oil supplies in August dropped by 720,000 BPD, with most of the decline coming from non-OPEC countries. But OPEC also experienced a production decline for the first time in five months, as supply fell by 210,000 BPD.

Strong demand growth and declining supplies are finally having the desired impact on high global crude oil inventories — which have been the single biggest factor behind the bear market in the energy sector. The formerly huge surplus over the five-year average has been falling steadily for months and has now reached 190 million barrels. 

The IEA notes that “OECD product stocks were only 35 million barrels above the five-year average at end-July and could soon fall below it because of the impact of Hurricane Harvey.”

On that same theme, a story last week from Bloomberg reported:

“Oil traders are emptying one of the world’s largest crude storage facilities, located near the southernmost tip of Africa, as the physical market tightens amid booming demand and OPEC production cuts.”

The energy sector has already begun to respond to the shift in the fundamentals, as the price of West Texas Intermediate has moved back above $50 a barrel.

Since mid-August, the Energy Select Sector SPDR ETF (NYSEARCA: XLE), which contains the largest energy companies in the S&P 500, has risen 10%. The S&P Oil & Gas Exploration & Production SPDR ETF (NYSEARCA: XOP), more representative of the small-cap drillers, has rallied 16.2%. 

Investors wishing to preserve some of the gains from the broader bull market should take note of the shift underway in the energy sector.  

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