Is there any Fuel left in the Energy Sector Bull Advance?

Canadian energy stocks have been bulling higher for most of the year. The iShares S&P/TSX Capped Energy ETF is up 18.68% year-to-date (as of Aug 28). This renewed strength in the energy stocks has been a major contributor to the robust bull market advance in the broader Canadian indices.

Can the energy stocks keep rising?

While there are a number of fundamental input variables and broader market conditions that must be taken into consideration, there is one underlying divergence that continues to raise red flags. This is the divergence between the underlying stock prices and the price of crude oil and natural gas.

The Divergence

January 2014 low of WTI crude oil was $86.00. Between January to June, crude oil prices have risen to a high near $105.00 (on the October contract) or a $19.00 rise. During that advance, the iShares S&P/TSX Capped Energy ETF has rallied from $17.00 per share to a high near $21.50. Since the June highs in crude, we have seen a steep decline of over $12.00 a barrel, bringing prices just a few dollars from the start of the year. At the same time many energy stocks have not reacted. As an example, Imperial Oil (TSX:IMO) is at $57.50 and trading at its 52 week high, Canadian Natural Resources (TSX:CNQ) is at $46.67 and just a few dollars from its 52 week highs, Suncor (TSX:SU) is at $44.14 and also just a few dollars from its highs.

The question to ask – Can the Energy stocks hold their robust gains and advance higher when the underlying commodity prices declining?

At minimum, we can conclude that the divergence does create short-term risk in fundamentally good stocks that can be owned for the long-term. With the current low implied volatility, buying short-term protective puts becomes an increasingly beneficial proposition.

As an example, an investor that has held shares of Imperial Oil throughout the year has participated in a $12.00+ advance from $45.00 at the start of the year to the $57.50 current highs. In consideration of the paper profits made, the investor can buy the October $56.00 put for $0.75 (as of August 28^th). For a modest cost, the investor can create a unique scenario where:

• The investor is guaranteed a $56.00 sale price if the stock drops in reaction to deteriorating oil prices.
• If oil prices were to bottom and begin advancing, the investor remains long the stock and continues to participate on all further gains.

In light of gains made and the divergence in crude oil prices, protecting the profits made over the short term may have some appeal to some investors.