Since the new year, the sharp fall in crude oil prices has been the most-popular topic for the financial media. And although a 15 percent pullback isn't uncommon for the volatile crude oil market, the rapidity of the move was unusual. Clearly, this sharp move has also had an effect on energy-related stocks.

I'm not one to try to call a bottom in either crude or related stocks, but any move for oil under $50 would be short-lived. I also see downside for most oil- and gas-related stocks limited to around 10 to 15 percent. The bottom line: This isn’t the end of the energy bull market--just a typical correction in the context of a long-term uptrend.

Typically, corrections end with a flurry of extreme bearishness and panic-driven selling. Just as traders are typically most bullish just before a top, they're also most bearish right near the lows. I’m already starting to see whiffs of such sentiment. Check out the chart below.



Source: Bloomberg

This chart is based on data from the weekly Commitment of Traders (COT) report released by the Commodity Futures Trading Commission. The data is based on the New York Mercantile Exchange crude oil contract.

Basically, the COT divides traders into commercial traders and noncommercial traders. Commercial traders are industry participants—such as oil and gas exploration and production firms and refiners—that use crude oil futures to help hedge their risks or lock in prices. Noncommercials are typically speculators--market participants making some sort of a call on the future direction of prices.

The chart above shows the total short commitments for the crude oil market. Recall that if you're short futures, you're betting on a decline in oil prices. Typically, when short commitments spike higher, it's a sign of growing bearish sentiment—just the sort of pessimism that tends to mark a low.

For example, on the chart, you can see prominent spikes in short commitments in October/November of 2005, around the time oil bottomed in the mid-$50s. You can also see some spikes in late 2004 and in early 2003.

Right now, short commitments are spiking back to near-record levels. In the most-recent report, short commitments for noncommercials jumped more than 27,000 contracts to 161,442. Long-side commitments rose by less than 10,000 contracts; speculators are betting aggressively on a decline in oil.

When it comes to energy stocks, I look at volume for a clue about traders' sentiments. Strong volume on declines and advances suggests institutional participation in the move. But extremes of volume tend to mark possible panic-driven trading and extremes of emotion. Check out the chart below.



Source: StockCharts.com

This is a chart of the Oil Services HOLDRs (NYSE: OIH), an exchange traded fund that represents a basket of oil services stocks. But I could have just as easily posted the charts of any number of individual oil services firms; the basic volume pattern is similar.

As you can see, the last time we saw volume get really extreme in this market was in late September and early October of 2006. As I suggested last year, this marked a key intermediate-term low for the group; oil services stocks rallied into December. I’ve also circled the extreme volume spikes that occurred near some past lows.

On this latest move lower, we’re once again seeing a huge spike in volume, similar to what occurred in the fall.

How To Play It

Neither the COT report nor the volume on the HOLDRs is an exact timing indicator; I’m not calling a bottom here. However, these factors do at least suggest that the conditions are right for a low to form.

I also see fundamental reasons for a turn. I see two primary fundamental catalysts for the selloff in energy stocks: warm weather across most of the eastern half of the US and an earnings warning from Nabors Industries (NYSE: NBR).

Since early fall, I’ve been writing about the developing El Niño phenomenon and its effect on winter weather. El Niño is a warm current in the tropical Pacific Ocean; El Niño years tend to bring warmer-than-average temperatures to the eastern US.

The market is already pricing in a warmer-than-average winter but remains sensitive shorter term to wintertime "heat waves", such as we saw last week. Moreover, we’re already seeing an impact on gas supplies resulting from the weather.

The Canadian drilling market looks very weak right now; activity has really fallen off a cliff in comparison to the past few years. As the No. 1 supplier of imported natural gas to the US, Canada's slowdown will have an effect on gas inventories.

This is exactly what we heard last week from Nabors. I’ve never recommended Nabors in any of my The Energy Strategist model Portfolios; in fact, I’ve rated the stock a "sell" for nearly a year now. The reason is simple: Nabors is leveraged to the North American land-drilling business.

North America is the drilling market that’s most vulnerable to short-term swings in commodity prices. There are a number of reasons for this. Basically, North American drilling is dominated by a number of smaller, independent producers undertaking relatively small-scale projects; these projects don't require a great deal of lead time and can be delayed.

In recent years, Nabors has also expanded into key international markets such as the Middle East; it’s important to note that this warning has absolutely nothing to do with these markets. International drilling activity is, unlike the US, not particularly sensitive to commodity prices. There isn't even an inkling of a slowdown outside the US and Canada.

My strategy for playing this market is twofold. With respect to traditional energy companies--companies leveraged to oil and natural gas—I recommend sticking to those with plenty of international exposure.

I also see firms leveraged to deepwater activity as relatively immune to the slowdown in Canadian and lower 48 states’ drilling. But there will surely be some volatility in these stocks during the next month or two; you may have to be patient.

Outside of oil and natural gas markets, there are plenty of secular bull markets that have seen no interruption. Topping my list is, of course, nuclear power. Any pullback in the junior uranium mining firms I recommend is a buying opportunity.

Elliott H. Gue is editor of The Energy Letter.

© 2007 Elliott H. Gue
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