Oil stocks were one of the few bright spots in the S&P 500 (SPY) during the bear market doom and gloom of 2022. However, that party could soon come to an end. Below I explain 3 reasons why oil stocks are no longer a bargain, plus reveal how you can still profit from oil stocks if they pull back from their recent highs. Read on for more….

Oil stocks were the only place to see any serious gains in the past year. But even the energy names look tired and toppy after an insane rally at the current level.

Looks like it’s finally time to take some profit and position for a big oil pullback…

For our discussion, we are going to use XLE, the Energy Select SPDR ETF, as a proxy for oil stocks. XLE’s two largest companies are the major oil companies ExxonMobil (XOM) and Chevron (CVX). Together, these two represent over 42% of the ETF’s weighting.

Oil stocks are overbought, but are weakening

The one-year price chart below shows the price action for the XLE. As you can see, XLE hit overbought levels on Wednesday before falling sharply. 9 day RSI hit 80 and then flipped. MACD approached its extreme before softening. Bollinger Percentage B approached 100 and then fell.

The shares traded at a high premium to the 20-day moving average. Previously, these indicators have aligned in a similar fashion, marking significant medium-term highs in oil inventories.

I have also pointed out the magnitude and length of the previous two rallies (purple lines). Notice how they coincide almost identically with the current price action in XLE.

Oil stocks are being extended versus stocks in general

The annual chart below of oil stocks (XLE) versus the S&P 500 (SPY) shows how good XLE’s outperformance has become for stocks in general. The XLE shows a robust gain of just over 60% in the past 12 months compared to a loss of almost 17.5% for the SPY.

Remember that the big oil stocks like ExxonMobil and Chevron are also in the SPY, which makes the comparative performance even bigger when the oil names are taken out.

Interesting to note that the last time oil stocks hit such highs in early June led to a significant drop, or mean reversion, in XLE. Look for a similar scenario to unfold, with XLE being a relative underperformer to SPY the upcoming months.

Oil stocks are way ahead of oil itself

Oil and oil stocks are generally well correlated. This certainly makes intuitive sense. If crude oil rises, oil inventories should follow and vice versa.

That was certainly the case for the first half of the year, as can be seen from the chart below. Both oil and oil stocks peaked in early June as West Texas intermediate crude ($WTIC) prices traded well above $120 barrel.

Since then, however, we have seen the $WTIC fall sharply below the $90 barrel, while XLE made a new high. This divergence has now been pushed to its limits. XLE has now outperformed $WTIC over the past 12 months by more than 50%.

I expect oil stocks to begin to decline towards the end of the year in sympathy with lower oil prices.

Traders and investors looking to take advantage of the expected convergence in XLE to lower levels can buy puts and spreads on oil stocks or sell out-of-the-money bear call spreads. We recently did that with a well diagonal on ExxonMobil (XOM).

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Good trade!

Tim Biggam
Editor, POWR Options Newsletter

SPY shares rose $4.99 (+1.34%) in premarket trading on Friday. Year-to-date, the SPY is down -20.33%, versus a % increase in the benchmark S&P 500 index over the same period.

About the author: Tim Biggam

Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as Market Maker for First Options in Chicago. He appears regularly on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His overriding passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.

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