Rising Crude Prices: Not Necessarily Good for Oil Stocks

During the past week, several economic factors worked in unison to push crude oil prices to an all-time high. The European Central Bank suggested that it might raise interest rates in response to inflation concerns in the European Union. This announcement pushed the euro up against the dollar and gave oil prices a boost as investors looked to hedge the falling dollar with an investment in a hard asset. The oil market got a further boost when Israel's transportation minister made less than flattering remarks about Iran. Iran is the second largest oil producer in OPEC and any supply disruptions from Iran would surely jolt the global oil market (a market in which oil production has been hardly growing over the past few years).

On top of this, emerging economies like China and India are still increasing their consumption of oil. Couple these developments in the oil market with the current economic situation in the United States (low interest rates, sluggish economic growth, rising inflation and rising unemployment) and it is not hard to see why oil is seen by many as the choice investment.

But are rising oil prices good for oil company stock prices? Normally, the answer to this question is yes, but, given the current economic situation, the answer is not so clear.

In order to get a better understanding of the current sensitivity of oil company stock prices to changes in oil prices, I collected daily closing data from January 2, 2008 to the present on two well known oil ETFs (the iShares Dow Jones US Energy (IYE), and the Energy Select SPDR (XLE)), the S&P 500, and the nearest contract on the NYMEX crude oil futures contract. For the year 2008 to date, IYE is up 7.35%, XLE is up 8.17%, and crude oil is up 32.9%.

I used a multiple regression model to separate out the effects of oil prices and general stock market movements on oil stock prices. So far this year, a one percent increase in the returns to the S&P 500 increased returns on IYE by 0.90% while a one percent increase in crude oil futures price returns increased returns on IYE by 0.47%.

In comparison, a one percent increase in the returns to the S&P 500 increased returns on XLE by 1.04% while a one percent increase in crude oil futures price returns increased returns on XLE by 0.53%. These results are useful in showing that oil ETFs have similar sensitivities to changes in oil prices (approximately half a percent increase in stock returns for each one percent increase in oil price returns) but that their market sensitivities are different.

XLE is much more sensitive to changes in the broad based stock market than is IYE. IYE and XLE are both more sensitive to movements in the stock market than movements in oil prices.

The current U.S. situation of low interest rates make fixed income investments look less attractive, especially since some of these investments are currently earning negative real returns. Sluggish economic growth, rising inflation and rising unemployment are not the signs that a strong stock market wants to see. In the long term, oil company stocks should do well, but in the short term, market corrections are likely to weigh heavier on oil stock prices than movements in oil prices.

Disclosure: Author is long IYE

Comments

[goodiedr:]

Even so, I was surprised to see the extent to which oil stocks were down on Friday - I expected them to go up, as it has seemed to me they loosely follow the changes in oil price more than the general market. The only explanation I can come up with - perhaps the selloff was caused by increased expectation of a pop in the oil bubble and quick profit taking before that happens. My What If question - what if the price of oil continues to climb next week, or hold steady - are the oil stocks more likely to reverse Friday's reaction and start climbing again - or will they most likely continue downward? (I finally jumped into PBR on Friday - feel good for the long-term, but wonder what to expect if oil price doesn't correct).

2008 Jun 08 11:53 AM

[Nate C:]

As someone who owns oil, nat gas stocks I am fully aware of this occurence. I am thinking about dumping the stocks and just by the actual commodities.

2008 Jun 08 02:47 PM

[yuman:]

The divergence between USO and IYE occurred before:
July 30, 2007 oil peak was accompanied by IYE drop. This happened also on Jan 3, 2008.
The peaking of oil preceded that of IYE by two months.

2008 Jun 08 04:43 PM

[Michael Fit...:]

Don't let the action in oil stocks on Friday scare you out of them! I don't care what anyone says, with oil north of $137 i want to own companies that produce millions of barrels of it a day (XOM, COP, CVX). i remember a wise man in san diego told me "the markets always do what they have to do to insure the fewest number of people make money". read that again. anyhow, point is, the oil stocks sometimes "correct" violently to scare out those johnny-come-latelys and weak of heart stockholders. earlier this year (just like last year) stocks like conoco traded down sharply to the low-70's. now, after all the turmoil, it's at $92. stock prices will in the long run follow earnings, and earnings are going to skyrocket at most energy companies. that said, i don't like pure refining plays as surely their margins will be squeezed bigtime.

2008 Jun 08 10:41 PM

[zenalgorithm:]

A wise pig once said, "That farmer is so nice to me, he keeps giving me more and more food!"

2008 Jun 09 12:57 AM

[CLH:]

With gold stocks the metal seems to follow the stock price. The mines go up first and down first. I always have believed most commodities do this also but I have no proof.

I am in DUG (short oil stocks) and Fri it didnt go down when oil went up. Hoping this continues.

2008 Jun 09 01:04 AM

[Jase:]

Nate: in just a few weeks, most major oil co's will announce their most profitable quarter in decades (a few like Conoco, Exxon, and Chevron are likely to set new all-time highs). Personally, I'd much prefer to hold their stocks through June/July earnings than hold the commodity itself. The recent correction last week have left most of these at very attractive prices. (Anyone here taking the opposite view? If so, would love to hear your reasoning.) I'd be surprised if Exxon doesn't break $100/share within a few weeks. I'm long some of these companies by way of several ETF's.

2008 Jun 09 02:10 AM

[DaveinHacke...:]

Jase is right: many oil stocks are a bargain now compared to the price of oil. I picked up some XOM when it dipped Friday, and I continue to hold EGY and BPT. Those are three wildly different oil stocks -- a mega cap integrated major, a small cap E&P, and a small/mid cap royalty trust -- yet they all have something in common: they all trade with enterprise values equal to about 9x next year's estimated earnings (which will probably be revised upwards soon).

In general, there is more potential upside in the stock prices of commodity-producing companies than in the commodities themselves. If it costs a company $40 to produce a barrel of oil, and oil is trading for $70, that company has a $30 profit. If oil prices double to $140, what happens to the oil company's profits? If costs stay the same (they don't, but let's assume they do, for the purpose of this simplified example), the oil company's pre-tax profits increase 333% ($30 to $100) on that 100% increase in oil prices.

Why hasn't the stock market priced this in yet? As I hypothesized on on another SA thread: 1) most of the oil bulls have been buying the commodity instead of oil stocks; 2) most stock market participants still don't believe $110+ or $120+ oil prices will continue. They'll come around when they start to oil companies start blowing past their earnings estimates.

2008 Jun 09 03:27 AM

[NOWHEREMAN:]

It really amazes me how minor moves in the price of oil scare both Longs and Shorts. Yes I said minor. Just a torpedo shot at a supertanker going through the Straits of Hormuz would pump up oil by $30-50, no sweat. Sink one or two, $100 is no problem. If you can't get oil out of the Middle East what will move up first? Producers, especially those outside of the US. Why because the US will probably try to do a "Chavez" on them.

The so called "less than flattering remarks", I call a declaration of the inevitable War between Iran and Israel. I don't know how you can call "Unavoidable" as anything else. Iran would not retaliate against Israel but could easily close the Straits. Might as well call it a plugged hole with 25% of the World's oil no longer available.

Israel will not wait if it looks likely that a man called Barak Hussein Obama is put into the White House. They will do their damage while they still have friends.

2008 Jun 09 08:31 AM

[mixter:]

As a fourth generation "oilie", I have seen and heard about the ups and downs of the oil industry for the last one hundred years. My personal experience started in 1958 when I graduated with a BS in Geology. The world was awash in oil, and the oil companies weren't as interested in finding more oil as they were in being able to sell what they could produce. Two people in my graduating class of 136 got job offers. A lot of experienced geologists were on the street looking for jobs. None of the Kennedy clan expressed any concern.

I also have a 1931 Amerada (now Hess) annual report. They lost 1.7 million dollars on revenues of 4.1 million. They lamented only being able to produce a portion of potential production due to curtailment policies in effect in almost all of the producing fields. For example the King Lease, Kettleman Hills, CA was completed with an initial production rate in excess of 20,000 barrels per day. However, the production rate was curtailed to about 4,000 barrels per day.

The average price of oil had declined from $1.23 per barrel in 1930 to $0.60 per barrel in 1931.

In the early 1980's, the oil bust resulted in approximately 600,000 people losing their jobs and hundreds of oil related companies going out of business. No one, especially the people from non producing states, seemed to care. However, let the situation turn around, and they howl like scalded dogs!

Now then, the "dim-wit-o-crats want to punish "Big Oil" for making billions of dollars or profits, albeit, it amounts to less than 10 percent of revenues. Talk about killing the goose that is laying the golden eggs! Just who has prevented drilling in areas that could greatly diminish the short fall of oil?

2008 Jun 09 11:17 AM

[ETFglobalin...:]

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2008 Jun 09 11:32 AM

[fxtrader07:]

@ETFglobal...: yeah, right. promote your site with your crap suggestion.
the stock market is in denial about the sustainability of the current oil prices. otherwise, the s&p would be 20% lower and stocks like cop, xom, apc would be 50% higher.
so the smart trade is long these stocks, short uso. all that talk of oil being up more tha n the oil stocks is backward looking and the author as well as several commentators make the very common mistake to write this trend forth into the future - which makes zero sense. rather, the pendulum will swing backwards. slowly, but at some point violently. if oil stays at current levels, companies like xom and cop will have earned their own stock price in less than 8 years. so after 8 years, the investment would have paid for itself. think about that! can you say the same about an outright investment in uso, or in oil futures? certainly not!

2008 Jun 09 03:58 PM

[billp37:]

"The oil market got a further boost when Israel's transportation minister made less than flattering remarks about Iran. Iran is the second largest oil producer in OPEC and any supply disruptions from Iran would surely jolt the global oil market (a market in which oil production has been hardly growing over the past few years). "

We hope that these unfortunate matters get settled peacefully.

www.google.com/search?...

2008 Jun 09 07:16 PM

[fxtrader07:]

global warming has little to do with oil and oil prices or oil consumption. contrary what Al gore and a bunch of so called experts want to make the world believe, we can hardly quantify 25% of the sources that are emitting CO2 and thereby are said to be responsible for global warming. if we take the share of the entire human civilization among these quantifiable 25% we arrive at 20% of 25% - or roughly 5% of the total. Now, the UN wants the world to waste 30 trillion to achieve some 20% reduction of our share at best. so we waste 30trillion to achieve an overall effect of - drumrolls, please, 1% of the total inputs that cause global warming. a single major mudd-volcano eruption will more than offset the entire effort! Think about that! millions are starving and dying from hunger every day - but our focus is to waste trillions on some theory that has not been proved anywhere to any extent. Just based on some human designed computer-models about the global climate.
Weren't the subprime-structured credit vehicles based on computer models designed by men? And look how great they did - with absolutely clear and 100% observable inputs. But even those failed! now think about those climate models where we know only a tiny fraction of the factors at work. Go figure...

2008 Jun 10 05:53 AM