Oil To Follow Gold: Producers Outperform Commodities

By Greg Tolpigin | More Articles by Greg Tolpigin

Technical Analysis, when done right, can be very powerful as it can give us a snapshot of history and compare how different markets performed through various cycles. Through this we can often produce a playbook of how the future may unfold. Developing trading strategies and portfolios then follow which in theory (and fingers crossed) evolve into real profits.

One of the areas of recent history that I am a little fixated on is the performance of gold producers versus gold prices and how this is a barometer for the recovery in oil. When gold prices bottomed in Dec 2016, many gold producers had seen their share prices bottom well before then and more importantly, their gains had well outstripped the gains in the underlying gold price.

The reasons for this stem from the actions that gold producers took during the prolonged depression in the gold price. As the gold price fell producers had been busy cutting costs, selling non-performing or non-core assets, raising capital and paying down debt. They also focused squarely on improving operations to maximize the return on their mines which all in all helped lower their All Sustaining Cost structures.

As a result many producers had very little to no debt at all and were highly leveraged to an improvement in the gold price. In fact, it didn’t really take an improvement in the gold price to see their share prices begin to reverse course and head higher. It took just a stabilization in the gold price which helped trigger short covering as the underlying, bottom-up fundamentals began to improve.

That’s why stocks like St Barbara Mines and Newcrest actually made their lows up to 12 months before the gold price did.

I believe we are witnessing similar circumstances with oil. The oil price has bottomed and while it may not reach much above the $50/bbl level as this is where US shale oil producers are able to pump more oil at a profit, the price has clearly stabilized.

Improvement in underlying fundamentals for many of the oil producers has occurred too. Many have raised capital, paid down debt, conducted downside protection through forward sales or put option buying in the oil price and have been selling non-core assets to help reduce the impact of lower oil prices. This makes them highly leveraged to any oil price improvement and a dangerous sector to short, triggering existing shorts to cover.

So like the gold sector we see similar circumstances surfacing and presents investors with an opportunity to profit from not only from a recovery in the oil price but even just a mere stabilization. Oil producers will outperform the oil price during this recovery so it is the place to invest and my current number 1 pick is Origin Energy (ORG). While there are many oil producers that have greater leverage to an improvement in the oil price directly, I believe ORG provides the best risk adjusted returns and the greatest potential to deliver decent dividends in the future. Moreover, the bottom-up potential for ORG outweighs its peers.

The benefit for ORG investors at the moment is the company has raised capital to pay down debt and has slowly been divesting non-core assets as it reduces its debt load. ORG has its utility retailing business which provides core stable earnings just like AGL, which is an attractive business in its own right. This raises the potential (which has been flagged many times before) of a split in ORG between the energy and the utility businesses. The upside value it can create could approach 15-20% which is attractive and certainly makes it a target for corporate activity. We have seen ORG bid for before in 2008 and while the business is different now with a greater portion in direct energy production, it is a lot cheaper.

As the oil price continues to recover and ORG pays down debt and cashflows improve – dividends become an attractive bonus to accompany the capital gain. This makes its current price not only a short-term capital gain basis attractive but also on a long-term investment as well. Take with this a share price that is now technically beginning to gather solid upward momentum from an exceptional base and it’s the perfect time to begin building a position in ORG. This has the ingredients for a consistent re-rating much like Newcrest and the mid-cap gold stocks did in the past 12 months. Wouldn’t we all like to go back 12 months ago and buy more gold stocks? Don’t make the same mistake with these oil producers. Once ORG breaks up through $5.80/6.00 this will trigger a more aggressive round of short covering, outright long buying and a vacuum of selling pressure that will lead to a sharp move back towards the $7.50/8.00 range. My longer-term target stretches towards $10.00 which is only back to where it fell from in mid-2015. Not a tall ask.

Greg Tolpigin

About Greg Tolpigin

Greg Tolpigin has over 20 years of experience as a proprietary trader and high-level strategist for the major investment banks including Citigroup, Bankers Trust and Macquarie Bank.

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