Crude Sell-off: Solid Entry Point into U.S. Oil Majors

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 |  Includes: COP, CVX, IYE, OIL, USO, XLE, XOM
by: Michael Fitzsimmons

In the last month oil has fallen from near $150/barrel to just under $118/barrel, about a 20% retracement. The talking heads on CNBC yesterday were celebrating this fact and talking up a much further drop in the price of crude.

Meanwhile, the past month was simply disastrous for those invested in oil and natural gas stocks (like yours truly). Money managers and analysts are now advising investors to jump into the financial and retail stocks and shun commodity investments like energy. Is the energy play over? What has fundamentally changed in the energy arena to substantiate the sell-off in energy stocks?

Let's take a quick look at the key factors with respect to oil supply and demand:

1) Has the US adopted a long-term strategic energy policy?

No. Obama is talking windfall profits taxes which will be detrimental to domestic oil and gas supplies in the future. Our do-nothing Congress has still not voted on offshore drilling. McCain has been pounding the table on nuclear and offshore drilling (good), but who knows if he will seriously get behind the wind, solar and electric transportation solutions so desperately needed. It's doubtful. One thing is clear, neither Presidential candidate nor Congress understands the nature of the energy challenges facing the US. This despite Boone Pickens's best efforts to educate them.

2) Have India and China stopped their transition from bicycles to autos? Did Russia and the countries of the Middle East stop buying automobiles?

No. Tata Motors (NYSE:TTM) has introduced a very cheap automobile in India. The world's automakers are successfully prioritizing China for auto sales since the North American and European auto markets have slowed significantly. Russia and Middle Eastern auto sales are still very strong. The majority of these new auto sales are more efficient than the average US automobile. That said, they will still be new consumers of oil. These countries now want to experience the good life that Americans have enjoyed for so long, and who can blame them?

3) Have Exxon (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP) increased production in the latest quarter?

No. Production at all three of the US majors was lower. That said, they all recorded record or near-record profits. Major projects are scheduled to come online for all three, but legacy reservoir depletion rates are still an issue. The door to many foreign reserves has been closed. It is increasingly hard and expensive for these US majors to replenish reserves. They are in no hurry to increase production today when they can do so in the future and sell the oil at ever higher prices.

4) Has worldwide oil demand fallen?

Not really. There was some demand destruction in the US and elsewhere when gasoline breached $4/gallon. This was quickly sucked up by emerging economies. There are signs that US demand is picking up again now that gasoline has dropped back under $4/gallon.

5) Have there been any large production increases by any single entity?

No.

6) Has Iraq signed oil contracts and has security improved enough to make good on them?

Arguably not. Although Iraqi oil production has improved and is near to pre-war levels (and occasionally higher than pre-war levels), it would be hard to consider Iraqi oil production growth as a given.

7) Has the Iranian issue been solved?

No. Geopolitical events in Nigeria, Iraq, Iran and elsewhere will continue to place a risk premium on barrels of crude oil.

7) Has the US currency strengthened?

Yes. The US $ index [NYBOT:DX] has, in the last few months, increased from 72 to nearly 74, or, 3%. This is not much of a gain considering the US currency has lost 50% of its value over the past 8 years.

One may conclude, from both a policy and fundamental perspective, the majority of demand and supply factors are still bullish going forward. Is supply meeting demand today? Yes. Is the margin thin from an historical perspective? Yes it is.

Besides, has oil really dropped so much? It wasn't so long ago that $120/barrel oil would have been thought of as catastrophic. Is there really a reason to celebrate given the worldwide oil supply/demand fundamentals listed above? I think not. It is not time to be complacent about the energy challenges America faces in the coming years. It is time to adopt a long-term comprehensive energy policy (now).

I do believe that oil replaced the US dollar as the world's "reserve currency of choice" and I still believe that to be the case. This did lead to a short-term spike in oil prices that was not solely dictated by supply and demand. Who could blame speculators for investing in a strategic commodity when faced with the financial crisis? Yet, I don't think all the cards are on the table with respect to the current US banking and financial crisis.

I also don't believe the Federal Reserve is in a position to raise rates and strengthen the US currency, nor do I believe the fiscal policies of the US government make a case for a strong US dollar. That said, I do believe you will see interest rates fall elsewhere, which could prove to strengthen the US currency a bit. But not a lot. The US fiscal house is in disarray, and the $700 billion per year we send to foreign oil producers will continue until such time as we adopt a strategic long-term comprehensive energy policy. I don't see that happening with either Presidential candidate.

I do agree with Bill Gross - the world is currently going through a huge financial asset deflationary cycle. All markets around the globe have been selling off, along with oil and commodities including gold and precious metals. I believe the Olympic Games in China are one reason for some of this deflation as Chinese officials have had to curtail business and travel in an attempt to meet clear air objectives for the Games. When the Olympics are over, it will be back to business as usual in China.

Should you sell your oil stocks for fear oil is heading much lower? Heck no. Hold your Exxon, Chevron and ConocoPhillips if you already own some. Their earnings are spectacular and will continue to be so, in spite of any windfall profits scenario. If you don't already own stock such as these, I believe time will show this to be a great investment entry point for these stocks. People forget that these companies will have expanding refining margins if the price of crude oil falls. At the same time, oil is still today over $118/barrel. These, and many more energy companies will be printing money for many many years to come. Look back at the 1970s as a guide to how oil and oil service companies performed during that energy led recession.

I feel the economies of the world will zig-zag in concert with the price of oil for the foreseeable future. Oil prices will have long-term rising slope predicated by the fundamentals of worldwide oil supply not being able to keep pace with worldwide oil demand. As oil prices rise, economies will contract. Oil will then dip (as they are now) until such point as economies are stimulated into consumption again, and oil prices will rise. This pattern will repeat, with the gyrations getting larger and more volatile as the oil supply/demand fundamentals get tighter and tighter.

If world "leaders", especially in the US, don't shed their "oil-denial" mindset and address the issue with intelligent policy, the economic implications will become more and more severe as time rolls on. Of course the US is the most exposed economy as it imports 70% of its oil. There is still time to make the necessary changes. Let's hope policy makers in the White House, Congress, and on Wall Street understand the significance oil will have on the US economy going forward. They certainly have gotten a preview these last few years. Have they learned anything from it, or are they just praying that oil continues to move down?

Regardless, good luck with your investments in these very, very challenging times.

Disclosure: Long COP