Will Oil Stocks Stay This Cheap?

The price of crude oil dropped again Thursday to rest at a 13-month low of $74, representing a 50% fall from the peak price of just under $148 only three months ago. The declining price has been mostly attributed to slumping demand from a stumbling global marketplace. Let’s think back to three months ago and you will surely remember that the price of oil, and more specifically the price at the pump, was the number one topic of conversation; the reason being that as everyone now realizes, oil is the lifeblood of our economy and when it gets expensive the effects are felt by everyone. Granted a lot has happened in the last three months and financial markets are extremely volatile, but oftentimes volatility can create opportunity.

Many investors surely noticed that the energy and basic materials sectors were down more than 14% Wednesday, and the question that must be asked is, “What is the true price of oil?”. That is a tremendously complex question with factors both economic and geopolitical, but it’s in our DNA at Ockham to try to break it down to what is important and actionable. Remember when crude first crossed over $100 per barrel, we wrote (Relief at the Pump: Don’t Hold Your Breath) that it would be a while before consumers and the economy would get a break from expensive oil. Well, now eight months later after substantial price appreciation, the oil bubble has burst, which is a blessing because I shudder to think what this credit crisis mess would be with the added impact of record high oil... can you say stagflation?

We invite you to look at a great article from The Wall Street Journal (Crude Counting: How Much Should Oil Really Cost?), in which the author inserts some valuable metrics by which to judge the current oil futures market:  “For the last 40 years, oil has represented more or less 2.5% of global GDP, Deutsche Bank says. That should peg oil today at about $59 a barrel.” This is a reasonable assumption that oil would tend to revert to its historical average price. However, as the article later points out, oil that is cheap to produce has become more and more scarce, and some oil these days costs as much as $80 per barrel to produce. Clearly, oil producers will not produce oil that will not make them money, and the laws of supply and demand will take over from there. If crude is being sold too cheaply on the international marketplace, supply will shrink and cause an increase in price. By this line of reasoning, the price of oil at $74 is already pretty cheap and a drop from here just means that the most expensive production projects will get put on hold.

So, the economic side of the equation seems to suggest that the global demand slowdown would need to be very significant in order to justify the price dropping too much further, but what about the geopolitical side? We cannot foretell what will happen in the future that might create a supply shock—be it war, political unrest, or terrorist activities—so we will not get into that can of worms. However, we can formulate a calculated guess as to the behavior of OPEC in its upcoming meetings (Nov 18^th). Rest assured, OPEC will want to do all it can to drive up the price of oil to line its countries’ coffers with oil money. So, the odds of OPEC cutting production are quite good, which suggests, yet again, that cheap oil is a thing of the past. OPEC member countries will be in an interesting position similar to that classic game theory example of the prisoner’s dilemma. While all member countries have an interest in proclaiming to the world that the cartel members are collectively cutting production, it is to their advantage to cheat the other members by selling more than they were allotted. Keep that in mind, when OPEC’s likely announcement comes in November.

So, it seems reasonable to us that the price of oil has overcorrected after the commodity bubble’s burst. These most basic of factors discussed above lead us to believe that for the price of oil to slip too much further, the global recession must be a major one to drop demand so drastically. If that indeed is the case, then no stock is safe and all bets are off. However, if that is not the case and the dip in global demand is shallow and brief, oil stocks will prove to be a nice investment right now. There are undervalued stocks all over this market, but energy stocks could be quick to rebound when crude begins to rise.

Some equities that interest us at present levels are Exxon (XOM), Chevron (CVX), Petrohawk (HK), and Transocean (RIG). We have attached throughout this piece the ratings history charts for each of these securities, and each one of them falls into our Greatly Undervalued rating at present levels. No one can know what the “true” or intrinsic price of oil is, but you must take the data and try to identify a trend.

Comments

[DickT:]

Your analysis contains two major assumptions which I think are not correct. 1) The cost of producing oil (or any other activity) is not carved in stone. As the world economy weakens, the price of drilling, shipping, wages etc will decrease. 2) Oil producers need cash... just like everyone else. They are not going to turn off the pumps and attempts to curtail production have never stuck. The expensive oil that has been stored will come to market.

2008 Oct 17 05:42 AM

[RSAAKS:]

Oil has always traded based on supply and demand more than the production costs. If trouble makers can stay calm and not blow up any pipelines, if winters stop being too cold, if subsidies for ethanol-solar-wind continue, and world deicded that nuclear is the way of future, then YES oil be head for $40. Otherwise, expect to revisit $100+, sooner or later.

2008 Oct 17 07:25 AM

[dsrtwriter:]

The first comment,suggesting that the input costs for oil exploration are indeed flexible downwards with a weakening economy, again ignores the fact that we are running out of "easy oil" reserves.

There is plenty of oil in more challenging areas, such as deep water, and of course, the oil sands of Canada.However the research and technology input costs required to extract this are predicated upon an assumption of an oil price range which will justify these costs. These input costs do not drop in price with a weaker economy; instead, if oil prices drop, these projects stay put on hold, and we continue to finish off our exploitation of easy reserves.'

If anything, it means that a weak economy ,with weaker oil prices, defers the needed exploration and development of large reserves which are more expensive to exploit. So unless we rapidly develop alternatives for petroleum products, for everything from cars to plastics,we may indeed face a huge spike in oil prices in a couple of years.

It can spike up just as rapidly as it has fallen.

Of course, one of the lessons that the OPEC countries should have but likely have not learned, is that there is a sweet spot in oil prices where we pay more and they do well. They got greedy, and when President Bush (reflecting our desperation due to no drilling in the U.S.) asked Saudi Arabia to increase volume, they were not enthusiastic.

The result? Consumers cut back, demand dropped (temporarily) and the price plunged.

It seems to me that a healthy price for oil, to encourage exploration and a decent rate of return, is in the 95-110 dollar a barrel range. But ultimately the market will determine whether we swing from $55 a barrel soon, back to $180 a barrel in three years.

2008 Oct 17 11:36 AM

[Wadhamite:]

No, they won't stay this cheap. Buy now while they are on sale.

2008 Oct 17 03:06 PM

[bill d:]

Greed is a wonderful thing.
Fortunately for us the Arabs & Venezula have a lot of that too.

2008 Oct 17 04:48 PM

[kurt walter:]

It is time for another congressional investigation. Why are oil prices coming down? Those jerks in congress were pandering for votes when they investigated high oil prices. Now, I want the same fools in congress to have another hearing regarding falling oil prices. I want them to do something about lower profits for oil company shareholders. These lower profits will affect pensions, mutual funds and 401k plans. I demand an investigation.

2008 Oct 17 07:09 PM

[principle:]

Kurt Walter, what are you talking about? We want oil prices down, youre just upset because you lost money on a stock. A barrel of oil should not double in price in less than a year, yet is seemed to quadruple in just 3 months. Oil prices should go up, but now at $70 we are getting closer to where it actually should be for unspeculated normal growth, where it should be more like $60. XOM I think will rise in value, so that stock itself should do great over the next 6 months, even if the price of a barrel doesnt climb.

2008 Oct 18 02:40 AM

[Diegojames:]

A CONGRESSIONAL INVESTIGATION IS A CHARADE . REMEMBER THIS IS THE SAME GROUP WHO GOT DEALS FROM COUNTRY WIDE and other kick backs from ACORN, FANNIE/FREDDIE lobby funds for parties,lovers and re elections
Do you want to find out that the OIL Companies are re electing CONGRESS???????THE RICH FARMERS GIVE BACK SUBSIDIES TO CONGRESS FOR RE ELECTION....IT IS A GAME AND OPEC WANTS THEIR MONEY TOO.
SO keep looking at CVX and XOM Income statements vs Cash Flow from Reuters (do they look ok to you?)
ONLY A PRESIDENT WHO CARES ABOUT AMERICANS CAN MAKE A DIFFERENCE in a start for a real ENERGY POLICY .....

DIEGOjames
vote for wind farms and solar parks......

PS WE ARE A COUNTRY WITH A BIG FINANCIAL PROBLEM CAUSED BY CONGRESS, CEO'S, PRESIDENTS, AND PEOPLE LIKE US NOT BEING RESPONSIBLE AND DEMANDING BETTER.

2008 Oct 19 02:13 AM

[James Sterling:]

The Greed of the big oil companies has been a major factor in producing our current recession and the results have backfired on the oil producers. The effects of the excessive profit taking of the oil industry will be felt for a long time.

2008 Nov 18 10:14 AM