Oil Is Due For A Rebound

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Includes: AREX, BBEPQ, CME, LINEQ, LNCOQ, MEMP
by: Daniel Jones

Summary

Despite negative sentiment regarding the price of crude, Mr. Market is indicating that the price of oil may be too low right now.

A look at the futures curve suggests that the upside from buying and storing oil over the next year is very meaningful, especially using margin.

For investors who own shares in this space, this is a sign that a move higher is probable, something that would certainly be bullish for stockholders.

With fears of a continued and potentially-growing supply glut, oil prices have fallen under pressure once again over the past week. As of the time of this writing, the price of WTI comes out to just $28.46 per barrel, far removed from the more-than $100 per barrel seen before the glut began to grow in 2014. Although there is no perfect indicator, by any means, of what the future market price of oil will be, however, Mr. Market does give some clues as to what market participants are thinking. In what follows, I will dig into some data and show that it appears as though oil is due for a rebound, something that should be beneficial for oil-related companies like Linn Energy (NASDAQ:LINE) / LinnCo (NASDAQ:LNCO), Memorial Production Partners (NASDAQ:MEMP), Breitburn Energy Partners (NASDAQ:BBEP), and Approach Resources (NASDAQ:AREX).

The futures curve is looking higher

The current price of oil I quoted above is for the futures contract that comes due in March. To see what Mr. Market anticipates over the next year, I figured it would be a good idea to look at what a company could guarantee as a purchase price for a barrel of WTI in March of 2017. Based on data provided by CME Group (NASDAQ:CME), that prices comes out to $39.26 per barrel as of the time of this writing. In the graph below, you can see the current futures prices for each of the months between March of this year and March of next year.

Click to enlarge

What this implies is that somebody could buy a barrel of oil today for $28.46, enter into one of these contracts, and be guaranteed a selling price of $39.26 per barrel a year from now. This represents a gain of $10.80 per barrel. On a percentage basis, this represents a gain of 37.9%, which is one of the largest disparities I've seen for oil a year out over the past several months (though the disparity during the last financial crisis was much, much greater). In the table below, you can see both the percentage and dollar breakups over the next several months. As a note, some of these contracts had no volume recently, which explains why some months are lower in price than the month before them.

Click to enlarge

Now, before you jump up and call your broker to get him/her to rent a warehouse and max out the equity on your home to fill said warehouse out, the actually return won't be that large. The reason behind this is that this disparity is gross, not net. This means that you would have to factor in other expenses associated with this strategy, such as rent, utilities, transportation of crude, insurance, etc... Many analysts suggest that this would normally cost between $6 and $8 per barrel over the course of a year, though I was in the planning process nearly a year ago and was able to get my theoretical costs down to between $4 and $5 per barrel (due to how short these disparities tend to last, I wasn't able to implement the strategy in time).

To be reasonable, let's assume that the mid-point of $7 per barrel from analysts' estimates is the most likely. Under this scenario, there's still $3.80 per barrel up for grabs, which turns out to a one-year pre-tax return of 13.4%. If you borrow 80% of the money associated with this strategy at a rate of, say, 6% per year, then the pre-tax return would be 42.8%. This goes to show the beauty of leverage.

It should be mentioned, however, that I'm not recommending that investors follow this approach. If you have the ability, time, energy, and are willing to take the risks necessary to make this happen in a timely manner, then more power to you but this isn't ideal for the vast majority of investors. Rather, I'm conducting this exercise to show you what some smart-money market participants are likely going over right now. Big hedge funds, companies, and some wealthy individual investors are likely to jump at this opportunity if this disparity doesn't narrow down soon.

For you, this presents another opportunity. Given the incentive to follow this approach and the fact that Mr. Market is offering it to those willing to jump in, this suggests that the market is behaving irrationally to some extent. One way this can be corrected is to see the current price of oil rise in an effort to close the gap. This should create some buying pressure on oil, which increases the probability of a rebound in WTI. In turn, this should prove beneficial for investors who are in this space, holding companies like Linn Energy / LinnCo, Memorial Production Partners, Breitburn Energy Partners, and Approach Resources, since they will ultimately benefit from a leg up in energy prices.

Takeaway

At this moment, it appears as though a market inefficiency is present. With the spread between current prices and futures prices a year out looking quite large, this should serve as a bullish indicator for investors, like myself, who are heavily invested in this space. This does not guarantee an upswing in the price of crude, but it does increase the probability of it happening by a good margin in my opinion.

Disclosure: I am/we are long BBEP, AREX, MEMP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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