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The Carnage in Oil Stocks is Incredible.

The carnage in oil stocks is incredible.  Small cap shares tracked by the Russell 2000 Energy Index (93 companies) have plunged 34% in three months.  Since June 26, these shares have plummeted 24% or about 6% per week.  For a year, these shares are off over 65%.

Bloomberg writes even with the 17% four week retreat in the S & P 500 Energy Index, the selling in the smaller cap issues have sent these shares to its lowest point versus large caps in 15 years.

As noted many times, Bloomberg writes the S & P 500 energy index is at the deepest discount as compared to the S & P 500 since at least 1992.  What is the discount of the smaller capitalized issues as compared to the S & P 500?

Are these smaller capitalized issues ripe for a rally partially because the 65% plunge suggests all 93 companies have been thrown out with the proverbial bath water?

Bloomberg reports energy companies in the Russell 2000 were the most heavily shorted in the index at the end of June representing 10% of the average energy company’s shares outstanding.  This compares with 4.5% in the overall index.

To write the incredibly obvious, the plunge in oil is the reason for this decimation.  Oil is heading for the biggest monthly decline since 2008.  Bloomberg reports short interest has increased exponentially in the oil market over the last 30-days.

I think it can be safely written that at least on a short term basis oil is vastly oversold.   The narrative is overwhelmingly bearish.  Small cap oil stocks have been wiped out regardless of merits suggesting there is blood in the street is an understatement.

Will the sentiment change?  And if so what would be the catalyst?  The only certainty in life is change, the catalyst of which will only be told by history.

I would like to mention five potential bullish oil events, events that have been ignored.

First, Libya’s crude production dropped below 400,000 barrels a day as the conflict has destroyed infrastructure.  Production was around 1.6 million barrels per day and is unlikely to return to this level given the damage to its infrastructure.  Is Libya a potential proxy for the remainder of the Middle East given the utter chaos in this region?

Second, Venezuela.  Venezuela is expected to default in 2016.  Venezuela’s leaders have stated that it “has no moral grounds to pay its debt amid shortages of basic things like toilet paper and medicine.”  Can or will creditors seize its assets?  Probably not.  How will this potential default and lack of options to cure the default impact potential Iranian deals where most believe the environment in Iran is less than hospital?

Third, Russia, the world’s largest oil producer.  Moody’s reports this commodity dependent country is bleeding capital, risking potential insolvency and the inability to reinvest in its infrastructure to maintain current production levels.  Capital outflows are projected to reach $90 billion in 2015 after last year’s record outflows of $150 billion.

Fourth, Saudi Arabia, the world’s second largest producer.  Saudi Arabia is operating around 110% capacity thus suggesting there is no spare capacity.  What happens if there is any type of disruption?  What about the economic dislocation with crude at current levels given that Saudi Arabia requires $85 oil to  meet its budget demand?

Fifth.  Greater than expected growth in the US, Britain and Japan, growth that might be materializing.

Some might suggest I am grasping at straws given my preconceived bullish outlook on oil.  However in eras past, any of the above would cause a rise in crude.

Speaking of which, both crude and the oil sector rose yesterday sending the popular indices up about 1%.  Was this advance only the proverbial “dead cat bounce” given that no market ever moves linear?

I don’t know but it is my firsthand experience when a narrative is overwhelmingly bullish or bearish, any change in sentiment can cause an outsized reaction.

Last night the foreign markets were up.  London was up 0.93%, Paris up 0.42% and Frankfurt up.  Japan was down 0.13% and Hang Sang up 0.47%.

The Dow should open quietly higher as 48 S & P 500 companies post results today.   The 2 day Fed meeting concludes today and little change in policy is expected but all will scrutinize the post meeting statement in an attempt to discern when the Committee will alter monetary policy.  Cynically speaking, the hype leading into this inevitable event will become myopically unbearable.

The 10-year is off 5/32 to yield 2.27%.

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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.