Exxon Mobil stock: Likely higher on momentum, but be careful what you wish for (NYSE:XOM)


Win McNamee/Getty Images

Remember when everyone thought Exxon would go bankrupt?

792 days ago, oil futures hit zero and then turned negative. Exxon Mobil (NYSE: XOM) lost about $22 billion in 2020, while experts happily declared the end of oil Company. Exxon, once the world’s most valuable company, briefly traded for a lower market capitalization than Zoom (ZM), the video chat company.

In November, Pfizer’s COVID-19 vaccine was found to be around 94% effective, completely shattering the paradigm that Western society “needs” to be locked down for five years or more. I wrote shortly after that Exxon may not have any friends, but they have plenty of customers. The stock was very cheap! It took just 12 months for Exxon to recoup its pandemic-related losses – all they earn now is gravy. XOM stock hit an all-time high this month.

XOM price chart
Data by YCharts

Politicians are again using the company as a punching bag for their election campaign. Typically, Exxon never really responds. Exxon has risen to the challenges of the pandemic for shareholders, maintaining and increasing its dividend and navigating the now-famous proxy challenge launched by activist hedge fund Engine No 1.

While I expect Exxon to continue to enjoy success, oil has become an increasingly crowded trade and valuations have risen significantly in the energy sector. With the stock trading a little above $90 here, I would take profits. At some point, the cycle will turn. To know when to fully exit, I would look at some classic oil market signals.

How to Trade XOM Stock: Signals to Consider

As we all know, oil is a cyclical business. But it’s not totally unpredictable. The seeds of the current oil bull market were sown from a drop in production during the early days of COVID. Likewise, the seeds of the COVID energy crisis were sown during the previous shale boom.

There are two indicators you can turn to to help you trade energy stocks.

1. The term structure of oil

There is an old principle in economics called the storage theory. It’s not widely known on Wall Street, but it’s very useful for making money in energy commodities. The basic idea is that energy is something that buyers need, and they are willing to pay a premium to get them on short notice when there are few. In contrast, the longer term commodity market is less chaotic and more rational. This means that the oil market generally (but not always) trades “backwards”.

The idea here is that when the oil market is tight, you can buy 3-6 month oil futures at a discount, hold them and sell them at market price when they are one month away. The return you get on this product is called a “convenience return”.

Checking the term structure of WTI and Brent crude confirms that indeed the oil market is stretched and it looks like a good trade.

WTI Term Structure - Storage Theory

WTI Futures Futures Structure, 06/21/2022 (CME)

On the other hand, when the oil market is oversupplied, the market trades in “contango”.

A well-known trading strategy is to buy oil or oil stocks when the market is in reverse and sell when it swings into contango. For example, this PIMCO article shows that crude oil futures return ~+28% per year in backwardation and ~-16% per year in contango. The oil market is backward about 60% from the long term and in contango about 40%, so it’s a very interesting signal.

The idea here would be to hold XOM stock until the oil market swings into contango. This signal indicates that Exxon is going higher in the short term, but there are reasons to be more cautious in the long term, which we will discuss shortly. I would still take some profit here, but I would watch the oil futures structure to know when to exit the position completely.

2.Momentum

Momentum is widely studied and certainly applies to energy stocks. However, the PIMCO study showed that offset was a much more effective signal. The idea would be that you hold Exxon until the upward momentum stops and then you sell. Typically you would use some kind of moving average like a 200 day moving average to help you gauge whether the momentum is with you or against you.

It makes intuitive sense, you have a profession that everyone crams into, so as long as they cram together, you hold on. However, when it starts reversing to the point where the trend is broken, you will exit. Momentum also indicates that Exxon may be trading higher in the short term.

The relative strength of energy is actually quite impressive this year, as of this writing, Exxon is up over 40% for the year, while the broader S&P 500 is up drop of just over 20%. But it could turn on a dime with a truce in Ukrainea global recession reducing demand or a number of other factors.

Both of these indicators can light up in no time. Don’t forget that oil reached close to $150 a barrel in July 2008 before collapsing to around $30 in December 2008! Food was also relatively scarce around the world at this time, largely due to soaring fertilizer prices. Sound familiar? 2008 was our last fight against stagflation.

Oil investors: be careful what you wish for

Dreams have recently come true for XOM shareholders, but past cycles show that good times don’t last forever. As we speak, the seeds are being sown for the next oil downturn. The higher Exxon goes up during the current bull market, the more likely it is to fall during the next bear market.

Two problems here.

EIA revises its 2022 global oil consumption forecast |  Oil and Gas Journal

Oil Supply vs Oil Demand (EIA)

First of all, there is now a huge incentive to source woodworking from somewhere in the world, simply because there is so much money to be made. The ban on Russian oil temporarily boosted the market, but the war could end or other countries could profit. Oil supply is very inelastic in the short term, but over time new supply should catch up with demand at some point. In other words, the price of oil is unlikely to continuously skyrocket. Even though the ruling politicians in the West keep blocking energy supplies from reaching the market, people end up getting upset and rejecting them. And OPEC members have been cheating on their quotas for a long time.

The second problem is demand destruction. The demand for oil is not very elastic in the short term, but in the long term, people change their habits and technology tends to compensate for the scarcity of raw materials.

This is not as common in rich countries, but in developing countries, a rise in the price of energy leads to a considerable drop in demand. If you lose money on your way to work, you might as well not work. For example, here is my updated commuting and cost of living spreadsheet now that 63 cents per mile is the new estimate for the cost of driving. (Relocation_Spreadsheet.xlsx).

If you’re buying a house 40 miles from your office, you better be able to work from home, or you’ve effectively sold OPEC a free call option on gas prices! Remote work is an option that was not viable during the last major energy shocks of the 1970s or 2000s, but it is proven today.

Electric vehicles have reached almost 9% market share in 2021, after being less than 1% in 2016. Solar energy production is also increasing exponentially. In 20 years, I expect these to be the dominant forms of transportation and power generation, respectively. There is also talk of a possible Congressional agreement that would encourage both US oil and renewable energy production, which would be a good down payment on the current energy crisis. All of these elements make the economy more resilient and less dependent on oil to function.

Solar Power Generation United States

Solar power generation (Statist)

Renewable technologies are advancing exponentially. It might not look like it, because it started from a low base, but the return on investment for things like electric vehicles and solar power is approaching the point where, as a household you can get 20-25% return on capital in areas where electricity/gas is expensive. to make the initial investment in renewable energy. Do not neglect this! Gas currently costs $6.40 a gallon in California and $8.50 in Paris or London. People are adopting electric vehicles not because they feel good inside, but because they save money. When I visited, over 80% of Ubers in London are now electric vehicles.

That shouldn’t deter you from investing in reasonably priced XOM stocks, as coal is the first fuel in the mix, not oil and gas. But at the very least, the pendulum of public opinion is likely to swing again at some point. The problem with Exxon now is that it’s not that cheap, making it a momentum game at this point, and a long-term investment that’s okay at these prices, but not great. It should be noted that during the stagflation of the 1970s, oil continually rose, but in 2008 a sharp drop in demand caused oil to fall. Whether the next recession looks more like the 1970s for Exxon or 2008 is an open debate.

Conclusion

Exxon is expected to earn around $10 per share in 2022, but assuming these earnings levels will last forever seems short-sighted (as were predictions that Exxon Mobil would go bankrupt in 2020). Cyclical stocks look cheap when they’re expensive and look expensive when they’re cheap, and Exxon is no exception here. Exxon is likely trading higher in the near term, but as summer turns into fall, I would expect a combination of higher overall energy supply and falling demand (global recession ?) lowers the stock. Of course, Exxon should never have been as cheap as it was in 2020, but we could look back at XOM’s price in 2022 and wonder why it got so expensive. Take profits on Exxon here and look to sell your position entirely if and when oil enters contango next.

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