Cuts to Production Won’t Protect XLE from Falling Oil Demand

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This morning I am recommending a bearish trade on the Energy Select Sector SPDR ETF (NYSEARCA:XLE).

Crude oil prices are up this week, and XLE looks like it is starting to recover from December’s selloff. But as I have said before, V-shaped rallies are rare. Unlike yesterday’s trade, today’s pick doesn’t have good news to carry it through overhead resistance.

Shrinking Supply vs. Shrinking Demand

In 2018, the Organization of the Petroleum Exporting Countries (OPEC) and Russia agreed to cut production of oil going into the new year. Generally, less production means higher prices. The price of oil is up, as you can see in the chart below.

Daily Chart of Crude Oil Futures — Chart source: TradingView

In the U.S., the number of rigs looking for new oil production has also dropped slightly. This means the U.S., which is now the world’s top producer of oil, is slowing the growth in production.

But the news isn’t all positive. Chinese trade data shows the global economy is slowing down. Yesterday’s small gains came after a 2% decline in prices.

Cutting production may boost prices, but if the economy slows and global demand for oil decreases, we will see steeper declines.

Retesting Before Recovering

Looking at the chart of XLE, we see the shares starting a downward turn after yesterday’s session. It is too soon to call this a near-term top, but XLE is at a turning point.

Daily Chart of Energy Select Sector SPDR ETF (XLE) — Chart Source: TradingView

Even if XLE doesn’t encounter resistance around the $62 level, there is still old support to overcome. Old support levels can act as new resistance, and before the selloff in December, XLE hovered above the $65 level.

I think XLE will retest its December lows in February. Even if it does recover from decreased demand for oil, it needs to find new support before heading higher. That’s why I am going to recommend a naked call option this morning.

Sell to open the XLE Feb. 15th $66 call for a credit of about $0.30.

Writing naked call options is a bearish position and is similar to shorting a stock, and it typically requires the use of a margin account. We are writing the call expecting that underlying shares will not trade above the $66 strike price prior to expiration. And we are hoping that the naked call option will lose value through time decay and will expire worthless at the Feb. 15 expiration. If so, we will keep the approximately $0.30 premium we collect at the start of the trade.

However, one risk is that XLE could unexpectedly move up sharply. If that happens, we would need to buy back to cover and close the naked call option for a loss.

The other risk if the stock moves up sharply is that the call will be assigned. This means that for every 1 call option we sold to open, we would need to buy 100 XLE shares on the open market at an unknown higher price and then sell the shares at the $66 strike price for a loss. Keep your positions small.

The stop is at $66.50, meaning close the position if XLE rises above $66.50.

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