The Rise and Fall of Oil: Roach Motel Theory

We all know how a roach motel works: Yummy food is placed inside an innocent looking box and the roach climbs in, finds some other roaches chowing down, and they all talk sports and politics and eat yummy stuff and have a good old time -- until one of them tries to leave. Then they realize the door really doesn't go both ways or, in the meaner models, they find out that sticky floor isn't just spilled beer -- it's glue!

Now the difference between roaches and fund managers is that a roach, finding himself hopelessly trapped in a position he can't get out of, is unlikely to go on TV to tell other roaches how great it is in there to entice them all to join in on the slim hope that he can gnaw his own legs off and crawl out over the suckers as they fall into the trap with him.

No, roaches have principles!

When I first started to write this article we were talking in comments and I mentioned that there had to be close to $1T in speculative money in the energy sector. Well I must have really pulled that number our of my butt as it turns out I was way off...

Major Integrated Oil & Gas alone has a market cap of $1.53T with just 11 companies in the group including ExxonMobil Corp. (XOM), Total S.A. (TOT), BP PLC (BP), PetroChina Co. Ltd. (PTR), Chevron Corp. (CVX) and ConocoPhillips (COP). This group has doubled since 2004, a $760B gain!

Independent Oil and Gas has over 100 companies with a market cap of $472B and top dogs include China Petroleum & Chemical Corp. (SNP), Occidental Petroleum Corp. (OXY), EnCana Corp. (ECA), CNOOC Ltd. (CEO), Suncor Energy Inc. (SU), Devon Energy Corp. (DVN) and Canadian Natural Resource Ltd. (CNQ). CNQ is up 500% since 2004 while the rest of the group is up "just" 200% for a $311B gain.

Oil and Gas Refining & Marketing has a market cap of $412B among 50 members. Royal Dutch Shell (RDS.A), Valero Energy Corp. (VLO), Imperial Oil Ltd. (IMO) and Marathon Oil Corp. (MRO) are the biggest companies in the group. The sector is up roughly 200% in 2 years, a $280B gain.

Oil and Gas Drilling and Exploration has a market cap of $328B with close to 100 companies. Petroleo Brasileiro S.A. (PBR), Statoil ASA (STO), Norsk Hydro ASA (NHY), Transocean Inc. (RIG), YPF Sociedad Anonima (YPF) and GlobalSantaFe Corp. (GSF) lead the pack. This sector is a mixed bag but up about 200% since 2004, a $216B gain.

Oil and Gas Equipment and Services has a market cap of $227B and 80 members. Schlumberger Ltd. (SLB), Halliburton Co. (HAL), Baker Hughes Inc. (BHI), Weatherford International Ltd. (WFT), National Oilwell Varco Inc. (NOV), BJ Services Company (BJS) and Smith International Inc. (SII) are the bigger names. The group has doubled in 2 years for a $110B gain.

Oil and Gas Pipelines bring up the rear with a $89B cap and just 30 companies. Williams Companies Inc. (WMB), Enbridge Inc. (ENB), Kinder Morgan Energy Partners LP (KMP), El Paso Corp. (EP) and Energy Transfer Partners L.P. (ETP) are the leaders. This group is up "just" 50% in 2 years because the fact-of-the-matter is we don't actually consume any more oil than we did in 2004. Still, that's a nice $45B gain in value! The fact that earnings at WMB are actually lower than 2004 doesn't seem to stop people from buying their shares because, after all, it does have something to do with oil!

So it seems I was way off, as actually $1.722T has gone into energy shares since 2004, more money than had gone into these companies in the previous 140 years of trading by a factor of 2 -- that's one crowded motel!

As Black Flag will tell you, it's easy to check into one of these energy stocks, all you need is blind faith that 140 years worth of investors before you have drastically undervalued virtually every single company in the sector by 70% while you have cleverly ascertained that this is the horse you are going to hitch your wagon of cash to.

Checking out, on the other hand, represents a large problem:

We'll use XOM as a convenient example, as it represents 10% of the total sector, and is the most heavily traded of all the groups.

Exxon has a $413B market cap, trading at $69 a share, up from $35 in November 2003. Every day 20M shares of XOM are traded with $1.3B of shares bought and sold. Over the course of 1,000 days since Jan 2003, buyers have outnumbered sellers to the tune of $200B!

As we said, it's easy to get in...

Don't feel too bad though for energy traders; the smart money has already moved out of this sector and into the industrials (and virtually every other stock), as it seems like oil's reign-of-terror may finally be drawing to a close. Those guys have had almost 2 full years to make a graceful exit with 50-100% profits as fresh money poured into the ever-expanding energy market. Now we play the real game of Survivor!

After rising from $35 in Nov '03 to $64 in Feb '05, XOM's stock pretty much bounced around between $55 and $65 for the past 18 months.

During this time, the second group of traders, the ones that had happily taken the place of the first group that had already come in and eaten most of the yummy food, employed the strategy that roaches would never: In order to save themselves, the second group of traders went on television telling all the other roaches how great it was inside the trap and how the yummy food and good times would never end.

They said there were terrorists outside, insatiable Chinese demand, hurricanes, declining supplies, cartels, war! In short, they did anything they possibly could to entice another round of roaches to enter the trap, and, when they got you stuck in the glue, these charming guys would then promptly gnaw their own leg off and crawl over your now trapped investment in order to secure their own freedom.

Like any good mammal, it takes you a while to decide the situation is so dire you need to gnaw your own leg off, and you "only" spent $70 for your XOM shares so $65 doesn't seem too bad -- certainly nothing to panic over...

That is how $1.3B worth of money can escape the Exxon Roach motel every day. That translates to about $13B out of a $4T sector that can find its way to daylight on a daily basis. As long as they can pull in another round of "savvy investors" at 40% over Oct '04 prices, when oil was a whopping $55 a barrel (up from $30 the previous year), everything will be fine!

But what happens when new investors are unable to appreciate the value of the energy sector? What happens when it's just you, $4T worth of paper, no more yummy food and lots of glue?

Since it would take 307 days of normal trading for everyone currently in the Energy Motel to check out (assuming they find new "guests" to check in at the prevailing rates) you can expect that some traders may be a little more anxious to leave than others and may end up offering slightly lower rates to new entrants.

What's worse (if you are a newer buyer) is that only in the past 100 days has XOM traded consistently higher than $60 so the basis of those sellers is quite a bit lower than yours.

If they already sold half their shares at $65-70 since July, or if their basis is much lower as they've been in energy a very long time, they can afford to get out at $50-$55 with no loss at all. Following GATG (Generally Accepted Trader Guidelines), they are likely to want to get out with no more than an 8% retracement, so we can expect a whole lot of leg gnawing at around $64!

Needless to say I am short on XOM as well as many other energy trades; we don't know precisely when the hammer will fall, but when it does there are going to be a lot of broken toes!

For brevity's sake, I confined this discussion to the energy sector, but a lot of these symptoms can be seen across all commodities but none so egregiously as it is with the oil plays.

Read all of Phil Davis's articles on Seeking Alpha.

Comments

[CrossProfit:]

According to your logic Phil, where should the DOW be? At 7000 or should we go back 40 years and 1000 is the correct accumulative value?

We get XOM earnings this week. Try to be a bit objective and then value the stock. The old 1 to 1 ratio doesn’t work anymore. Try applying 1.18 to 1. The reason is simple. 1 to 1 is stock to oil price up to about $35. Once above, the fixed costs start coming down drastically as a percentage of sales, resulting in increased margins. Also throw in a 7% lower share count and at $55 oil you’re at 1.18.

2006 Oct 23 09:00 AM

[MarineCorpsVet:]

Well, CrossProfit, you can say what you want but I still like the "Roach Motel" theory. It could almost become a law since it does seem to be universal. Phil is too smart to have missed the point you make. He is on another plane of the market.

2006 Oct 23 10:11 AM

[Ray Lopez:]

Has anybody considered the fact that perhaps "Peak Oil" is the reason oil is rising (aside from China's increase in demand)? Note also the below article, implying 40$/BBL is a floor. RL

Market Scan
Shell Grasps At Oil Sands
Scott Reeves, 10.23.06, 12:45 PM ET


Royal Dutch Shell effectively told the world on Monday that it does not think that oil prices will decline from current levels. The energy company said it would pay $6.8 billion to buy the 22% of Shell Canada that it does not already own, giving it access to the subsidiary’s growing oil-sands division.


The oil sands are profitable when the price of crude is above about $40 a barrel, so Shell’s interest is a sign it does not think prices will fall below that level.

Oil has risen about 80% since 2003, making Canadian sands projects competitive. The price of a barrel of oil peaked in July of this year at $78.40 and traded Monday morning on the New York Mercantile Exchange at $58.58, a decline of 25.3% from that level. The recent drop has led the Organization of Petroleum Exporting Countries to institute a production cutback, although oil traders seem unconvinced that it will be able to increase prices from the current level.

Shell Canada strip-mines oil-bearing sands and heats them to remove heavy crude. Its oil sands unit earned $790 million Canadian ($700.3 million) last year, 39% of the company’s $2.01 billion Canadian ($1.78 billion) earnings. In 2004, the oil sands division brought in just $378 million Canadian ($335.1 million).

Sarah Emerson, director of petroleum at Energy Security Analysis near Boston said the planned acquisition is an effort by Shell to expand its holdings and spread the risk.

"This doesn’t represent a right angle turn from traditional sources," Emerson said. "It's a portfolio approach to expanding reserves and spreading the risk. The price per barrel has to be in the $40s to get some kind of return from oil sands and current prices accelerate interest."

2006 Oct 23 03:10 PM

[Paul Meisel:]

There is certainly some speculative component, but several of the majors have very reasonable PE ratios and seem that they would still be profitable at $50 a barrel.... I think that, like the braoder market, some things are priced above where they should be, and some are not.

2006 Oct 23 04:47 PM

[Vladimir Se...:]

I agree with Paul.
Phil on the other hand doesn't believe that $50 a barrel is . . . (insert your favorite word in here, because i just can't pick one).
He'd like you to believe that oil is worth 20, no, forget 20, 10! It's not even worth 10 in fact, it should be free. No, we should be PAID to take it off OPEC's hands!
He is one of those roaches that go blogging about how great it is to be short major oil.
And he is the first one to bring up the chart and show you how great major oil did in the last 2 years. So i guess he wasn't short major oil for all this time? Why not? Wasn't oil too high back in 2004 as well? As far as i remember we still had to pay for it back then, OPEC wasn't paying us to take it . . . so it must have been too expensive.
I'm glad Phil's put have been doing better recently.
Big oil is as evil as we allow it to be. Any player in any game will and should take advantage of anything the game allows. If the rules of the game are "not fair" that just means you are on the wrong side of the trade. That doesn't make the rest of us evil.

2006 Oct 25 06:37 PM