Upside to Oil Stocks?

Oil prices continue to soar. The oil price boom over the last several years shows no signs of stopping. While oil traded below $20 per barrel as recently as 2002, oil prices have skyrocketed over the last 5+ years to reach levels above $130 per barrel. This represents a +500% increase in oil prices and helps to explain why prices at the gas pump have risen so sharply in recent years.

Fundamentals suggest oil prices may rise further in the years ahead. While some on Wall Street might believe that oil prices are unrealistically high and will eventually come back down, the underlying fundamentals suggest otherwise. First, existing oil supplies are limited and the potential for adding new oil supplies is gradually diminishing over time. Second, demand for oil remains strong and continues to rise, particularly from emerging economies such as China and India. Third, global oil drilling and refining infrastructure is aged and deteriorating, resulting in oil production breakdowns and supply bottlenecks. Finally, a meaningful percentage of the world's oil is sourced from politically unstable regions leading to periodic and unexpected supply disruptions. Thus, while short-term oil price corrections should be expected along the way, all of these factors support a higher long-term trend for oil prices.

Oil stocks have not participated in the recent increase in oil prices. From 2002 to early 2007, the correlation between oil prices and oil stocks was fairly high. In other words, as oil prices rose, the prices of oil stocks also rose at a comparable rate. This relationship has disconnected since last summer, however. While oil prices have risen over +80% from $70 per barrel to over $130 per barrel since July 2007, oil stocks have increased by only about +20%. This difference has been largely driven by the investor expectation that oil prices will eventually decline instead of rising further in the future.

Oil stocks now present a particularly attractive opportunity to capitalize on higher oil prices. If oil prices were to rise further in the years ahead as might be expected, oil stocks now have a sizable gap to catch up on the upside. Even if oil prices were to sharply correct toward the $100 per barrel range in the near-term, oil stocks still have roughly +20% of room to move higher based on this historical relationship. Moreover, oil stocks are now trading at particularly attractive valuations at 10x earnings, which represents a 15% discount to the historical multiple for the sector and a 45% discount to the valuation for the overall market at over 18x earnings. Not only is it reasonable to expect that oil stocks will make up this discount over time particularly if oil prices continue to move higher in the future, it would not be surprising to see oil stocks eventually trading at premium prices given the positive underlying fundamentals supporting the sector.

Conclusion: After trailing oil prices over the last year, oil stocks now offer the potential for meaningful upside going forward.

Full Disclosure: No Long or Short position in the XLE or Oil ETFs

Comments

[andys2i]

Great article. I recently wrote about this in my blog and why I like Oil stocks for my porftolio. I couldn't decide which stock to pick so went for the ETF which invests in the major oil and related services companies - IXC. I think this is a safer and less volatile bet.

[bos]

The discrepancy between rising oil prices and oil stock prices rising to a lesser extent might be due to the increasing cost of crude oil production. The oil companies have to drill deeper, further off-shore, or process tar-sands at higher cost. Increasing investment costs for alternative energy sources by these same oil companies may also explain why oil stocks have risen comparatively less.

[André Sautou]

This news is very interesting and clearly presented for ordinary citizens.

I share Eric Parnel’s analysis. But I also think that oil prices have now begun to pass the threshold beyond which further increases could substantially slow down world economic growth, up to a point that demand for oil might fall sharply while the world recurs more and more massively to coal, nuclear, renewables, further improvements in energy efficiency and restraint from using energy for non necessary purposes. And therefore prices could stop rising, stabilize for a while, and maybe slightly decrease.

Many investors may feel the same, and that perception may explain their hesitation about betting about further important increases …

[yuman]

Historically, did oil stocks trail oil prices? Did they oscillate, 1997-1999, in comparable magnitudes?
The chart seems to show that XLE participated in the rises and falls of USO in lock step. Besides the fundamentals, are there other evidence that XLE trails oil prices?

[mcadoo3312]

The supply and demand imbalances expected in the future give a reason why oil should be higher, but not necessarily as high as it has climbed - especially so rapidly. The flows of funds coming into (and staying in) the futures markets has been driving up the price based on these fundamental expectations. If these new entrants are forced to cash out, the upward price momentum gets its feet cut out from under it. Right now, oil prices are the hottest issue in an election year, and the candidates, as well as Congress and President Bush, have all given proposals to cool down the oil market. Even though the street has already been expecting a drop in oil prices, most stocks have still gone up. If oil falls based on enacted legislation, smart investors will capture gains in hope of buying the same solid companies back more cheaply in the future. In the long term, I agree with your theory, but in the short term, investors entering the energy market could be in for some pain.

[Eric Fox]

The OECD uses 48 mm Barrels per day while China uses only 7.3 mm barrels per day. The estimated growth in China consumption of only 400 thousand barrels will be overwhelmed by the drop in demand in the OECD. Do the math.

[zenalgorithm]

This article is written like those pamphlets you get so much in the mail lately about investing in oil funds.

The last time I received so many pamphlets/junk mail about funds for a specific industry that was taking off and was going higher was for networking stocks circa early 2001.

There is a huge imbalance right now threatening to overwhelm world economies - oil price. I think current oil prices will send the world into a great depression which could severely weaken demand. This expensive oil is driving up food prices higher and higher, and many people could die in the third world...

I think these expensive prices will bring a swifter end to the age of fossil fuels.

Be careful, if this economy tanks hard again - like most think it will - the strongest performing industries usually are the last to follow the big dive.

[Jim Kingsdale]

To Eric Fox: your point is directed to the right subject but is far from complete. The countries that are increasing their oil useage include, in addition to China: India, the rest of the Far East, Russia, Mexico, virtually all of South America, and most importantly the Middle East. I'd love to give you a number for the sum total of demand increases in those countries but I don't have it. Can someone else provide that number? My SWAG on it would be somewhere around 1.5 mb/d per year. OECD countries, on the other hand use about 45 mb/d and might see a decline of about 1% in use due to higher costs, which would be 450 kb/d.

[john s. gordon]

integrated oil company valuation multiples will be adjusted once we see the november election results.
> jack

[paulk8756]

Jack,

What does that mean...? Would it be bullish or bearish for oil...? Thank you.

[john s. gordon]

paulk - depends on the composition of the whitehouse & the senate. looks like we can now predict the composition of the H of R, remember it takes only 41 GOP (greedy oil party) senators to bring meaningful legislation to a screeching halt.
> jack

[Eric Fox]

Jim Kingsdale...I got my data from the EIA website here:

www.eia.doe.gov/emeu/s...

On the right side under the section called Tables, you will see:

3a. International Petroleum Supply and Consumption html

It lists the OECD consumption as 48.71 mm BD for the 30 countries listed in Footnote B as being in the OECD - Mexico is listed as one as is South Korea.

The only growth in consumption of oil in the OECD that is estimated from 2007 to 2008 is Canada, Japan and other OECD with a combined growth of 100K BD. Overall consumption in OECD is estimated to be down 240K BD.

The growth in consumption as you said is coming from non-OECD and the EIA estimates growth from 2007 to 2008 at 1.25 mm BD giving us total world growth in consumption of 1.00 mm BD.

China growth from 2007 to 2008 estimated at 422K BD.
FSU growth from 2007 to 2008 estimated at 130K BD.
Other Non-OECD growth from 2007 to 2008 estimated at 610K BD.

Russia is not broken out separately but is in FSU.

Middle East in not broken out separate but I assume it is in Other Non-OECD.

[Eric Fox]

It is my opinion that demand will fall short of the estimates that are currently discounted in the price of oil. Most of this decline will come in the OECD as you state.

An increasing price of oil should create the following situation:

1) Less demand for oil.

2) A crowding out of spending on consumer discretionary items in the U.S. as we spend more on gasoline, food and other items.

3) A contraction in economic growth in the U.S since our economy is based on consumer spending.

4) A cutback in demand for exports from Asia due to lack of demand accelerated by the increasing costs of those exports as the dollar weakens, and as Asia is forced to raise prices due to higher raw material costs (not just oil, but steel, plastics, etc.)

I think the market is too fixated on supply and it may not realize that elasticity of demand for oil is not linear.

You've been in the markets for many years. I am sure when you look at a chart, you can recognize when a financial instrument is trapped in an upward price momentum channel. Oil trades no different that a stock. Momentum is one of the most powerful forces in the universe, and a very successful trading strategy for those who are inclined to use it. What is that quote say:

“It is one of the great paradoxes of the stock market that what seems too high usually goes higher and what seems too low usually goes lower.” - William O’Neil