Higher Oil Prices Mean It's Time to Sell Oil Sensitive Stocks

Includes: COP, CVX, OIL, USO, XOM
by: Aaron Foster, CFA

Recent turmoil in the Middle East and its effect on oil prices has dominated headlines of almost every major news publication this month. The protests that started in Tunisia and Egypt earlier this year have inspired rebellious behavior in other nearby countries. Although war in any part of the world is reason enough to catch the eyes of the investment community, this particular situation is especially important given the potential impact on oil supplies in key regions such as Libya and Saudi Arabia.

The price of oil has risen over 20% in the last month, which has already translated to higher prices at the pump for U.S. consumers. The average price paid for a gallon of gasoline in the U.S. has increased 33 cents since the end of February, and 77 cents from one year ago. If you assume that your car drives the average 12,000 miles per year, and achieves 23 miles per gallon (MPG), you will be faced with $400 of extra costs this year compared to last, per vehicle. There are estimated to be 2.28 vehicles per U.S. household, which basically means that the average household will be without $900 they may have spent on other discretionary items.

While this is obviously not something we ever want to endure, it is particularly bad timing given that the economy appears to finally be digging itself out from the last recession. These events will certainly be a headwind to consumer spending and corporate profits this year, but shouldn’t have a severe enough impact to completely derail the economic recovery. The consensus opinions of economists are predicting that the GDP, which already currently stands north of $14 trillion growth, will grow 3% in 2011. While this is encouraging news for the U.S. economy as a whole, the pain will unfortunately not only be felt at the pump. Expect airfare prices, cab rates, shipping costs and several other types of transport-related fares to increase soon for consumers, and for some corporate profits to be impacted by higher input costs.

It’s worth noting that the stocks that have historically shown the most negative sensitivity to oil price changes have been airlines, specialty retail, and air freight & couriers. Expect stocks in these industries to experience selling pressure should oil prices remain elevated. The industries that have historically shown the most positive sensitivity to oil price changes are energy equipment & services, metals & mining, gas utilities, and oil & gas.

Before making changes to your portfolio, however, it’s important to understand that the recent run-up in oil prices has been rapid and mostly attributed to psychological fear. There have been very few actual disruptions to oil production in Libya, which have been reduced from approximately 1.4 million barrels per day to just under half a million barrels per day, which is only a small fraction of the overall world oil production of approximately 75 million barrels per day.

A much larger fear is that neighboring country Saudi Arabia will ultimately face the same fate as their neighbors, and battling between angry activists attempting to overthrow the government and police and/or the military could affect their oil drilling. Any disruptions to oil production in Saudi Arabia would prove to be much more detrimental considering they produce 10 million barrels of oil per day. Although it’s highly likely that not even half of the production in Saudi Arabia has much more than a remote chance of being disrupted right now given the location of the oil wells relative to the potential areas of social disruption.

The other important factor that impacts oil prices is, of course, demand which has shown mixed signals as of late. The U.S. economic and jobs outlook continues to show signs of marginal improvement, but hasn’t clearly established a significant turnaround. China’s imports of oil have continued to increase, but their business exports have shown signs of weakness recently which could indicate that global demand for their products is slowing.

The U.S. government could also help the supply situation in both the short and the long term. First of all, there have been talks already that President Obama may tap the strategic oil reserve should oil prices continue to rise, which would alleviate some of the pain being felt by consumers at gas pumps. Also, a more long term fix would be for the Obama Administration to speed up the process in which permits are granted for off-shore drilling. The moratorium took more than 1.6 million barrels out of daily oil production. A return to normal levels of off-shore drilling alone could completely replace the total daily oil production in Libya.

In conclusion, the potential for serious supply disruptions are real, but the likelihood of such an event occurring is unknown. The logical assumption is that the market has priced in the probability of a disruption and that corporations have planned to deal with sudden spikes in oil prices and will not suffer as they may have in 2008. Recent comments by managers of businesses such as Deere (NYSE:DE), Caterpillar (NYSE:CAT) and Union Pacific (NYSE:UNP), have all indicated that they are cognizant of increased input costs related to elevated commodity prices, but intend to pursue business ventures as previously planned.

Given the fact that stocks such as XOM, COP and CVX have already had major increases, the benefits of higher oil prices are most likely already priced in. Now is actually the time to start pocketing gains by selling shares until more evidence surfaces that can support the already significant changes in market values for the companies that have experienced rapid increases due to escalating oil prices. Although it is difficult to put an exact price point in which it will make sense to re-enter, a 10-15% price correction from today's price for oil, which currently stands at $100, would be a solid starting point.

Of course, any further developments in the Middle East could completely change the situation on any day. However, for now, it appears that oil has had its run for at least the near term, and selling oil sensitive stocks while waiting for a correction could prove to avoid some losses for investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.