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In our previous articles on the Seeking Alpha [1, 2, 3] we demonstrated that the evolution of ConocoPhillips (NYSE: COP) share price can be accurately described by a model based on the share price decomposition into a weighted sum of individual consumer price indices (alternatively PPIs). Both defining CPIs (PPIs) may lag behind the price. This model has been working since 1982 with one structural break around 1998 [2]. This break was related to the change in the long term trend of the difference between the core and headline CPIs [4].

Figure 1 reproduces the observed and predicted COP prices in order to demonstrate the predictive power of the pricing concept. In Figure 2, we depict the model error between 1998 and 2012. One can see that the cumulative model error approached the zero line, i.e. the regression line coincides with the zero line. In other words, all deviations of the actual price from the predicted one are only short-term and the predicted curve might be considered as a "fundamental" one. For ConocoPhillips, we have estimated the following relationships to minimize the model error between 1998 and 2012:

COP(t) = 72.3 - 5.35(CC(t) - C(t)) (1)

where COP(t) is the share price in U.S. dollars at time t, CC(t) is the core CPI, and C(t) is the headline CPI. This relationship is slightly different from that in [2] where we did not minimized the model error.

Figure 1. Historic (monthly closing) prices for COP (black line) and the scaled difference between the core CPI and the headline CPI (red line).

Figure 2. The model error for COP. The regression line shows that the cumulative error approaches the zero line.

There is a good reason why we discuss the price model for COP over and over. It provides a good benchmark when we estimate quantitative models for different companies. With the predicted and measured COP prices in Figure 1, it is difficult to deny that energy (in one form or another) drives the evolution of ConocoPhillips. To many readers and/or investors this thought might be a trivial and obvious one. However, the thought that CPI components can drive share prices is not so trivial when we describe the prices of companies from different sectors and industries (e.g. BAC from Financial). The very same approach is treated as an inappropriate one.

In any case, there is no strong criticism of our models for energy related companies we continue presenting them with the case of Newfield Exploration Company (NYSE: NFX), an independent energy company, engaged in the exploration, development, and production of crude oil, natural gas, and natural gas liquids. As for many other companies, we tested two principal pairs of CPIs: C and CC; CC and the index of energy, E, as well as the pair the PPI and the producer price index of crude oil, OIL. The best fit (we used the LSQ technique) model is obtained with the pair CC and E:

NFX(t) = -4.45CC(t-1) + 0.40E(t-0) + 17.48(t-2000) + 587.71 ; sterr=$7.18 (2)

where NFX(t) is the share price in U.S. dollars. We allowed both time lags (CPI leads the price) in (2) to vary between 0 and 12 months. However, the best lags are one and zero months, respectively. The index of energy drives the price up, and the core CPI affects the price negatively. Figures 3 and 4 depict the observed and predicted monthly prices and the residual model error, respectively.

The overall agreement is not good when compared to that for ConocoPhillips. Moreover, the model residual has been growing since the second half of 2011. Currently, the error is -$24.4, which is an extremely high residual. Now it's time to use the COP model as a reference. In line with the interpretation of the COP model error, one might consider the predicted NFX price as a "fundamental" price. Since NFX is much smaller than COP its price is subject to higher fluctuations. Accordingly, the current excursion is just a short-term deviation. Then the NFX price is highly undervalued.

As an alternative explanation, one may suggest that the model has failed on NFX. We cannot exclude this explanation but then why the concept works for the biggest energy companies and has also been working relatively well before August 2011? Thus, we expect the NFX price to rise to the level of $60 per share in the near future, i.e. to return to its fundamental price.

Figure 3. The observed and predicted monthly closing prices for NFX between July 2003 and |March 2012.

Figure 4. The model residual error.

There is another interesting question why do the other two pairs of defining indices have larger residual errors? Obviously, all three oil related indices, i.e. the headline CPI, the index of energy and the producer price index of oil, are tightly linked but are also affected by different goods and services included in the CC and E. The evolution of these defining indices differs accordingly. On the other hand, there is some true set of goods and services which do define the evolution of the NFX price. Then the intercept of this true set and those comprising the CC, E, and OIL should mimic the behavior of the true defining set. In other words, all three studied indices are just proxy to the true one. As a result, their predictive power may vary with time.

Source: Newfield Exploration Company Is Highly Undervalued