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

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 (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 (XOM), Chevron (CVX), and ConocoPhillips (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

Comments

[Ishortyou]

Nah, we not going to use oil anymore too much of a headache and poluting, we just gonna stick with non fossil fuel technology like electric or hydrogen-water even for airplanes.

2008 Aug 06 07:31 AM

[mangolfer]

I've been shorting oil and making a fortune since early July. As you know, prices always drop faster than they go up and it went up to fast. There is way too much media, demand destruction, and BS surrounding the price rise. I suggest you get out now while you can....

2008 Aug 06 07:44 AM

[redbaron]

Well said, Fitzman.

2008 Aug 06 07:51 AM

[CLH]

The main reason for the commodity crash is the turnaround of the dollar. This has only started.

2008 Aug 06 07:53 AM

[Fedman]

You should stay in oil, but only if you have an estimate for what the price of a barrell of oil should be. Is it $200, $150, $75? The recent run up shows that demand destruction does occur at some point, just as a longer-term higher average price will show more development and investment on the supply side.
You say that there have been only small changes in supply and demand, but there has been a huge change in price, which likely overshot the equilibrium price, just as the current reversal will likely undershoot the price.

So for me, I'm waiting until hurricane season is over, summer is over, and winter heating demand hasn't kicked in, and then, depending upon the price of oil and Ngas, I will go long. I don't think it is the time just yet.

2008 Aug 06 08:13 AM

[viva]

Nancy Panoche sees her mission as saving the planet. There will be no long term energy policy coming out of the US Congress which includes using US resources. SNAFU.

2008 Aug 06 08:36 AM

[jjason]

Someone on Seekingalpha recently said " the price of oil doubled in the last 12 months but DEMAND did not double." This was a good comment.

Now, perhaps, there are more people who know that we are being cheated by OPEC, Big oil, Government regulators who are not doing their jobs ( like the Commodity Futures Trading Commission ), oil futures traders and speculators, and are finally doing something about it.

Go to:

www.stopoilspeculation.../

AND SIGN THE PETITION.

Send Michael Greenberger's report to your Congressman and COMPLAIN.

www.commerce.senate.go...

and tell your friends how former Senator Phil Gramm is responsible for allowing the American people to be CHEATED.

Also, if something is wrong with the link to the US Senate Report, type Michael Greenberger into the search box at the top of the screen.

It's the "ENRON LOOPHOLE" FITZ. And Congress is going to fix it...and we might see oil at $60.00 a barrel...which is what oil is worth.

2008 Aug 06 08:40 AM

[truthinvesting]

Fantastic article. I think Exxon s getting real cheap considering that as places to put your money gets smalle Exxon is a safe place to park cash. real estate and fixed income is not appealing

2008 Aug 06 08:56 AM

[CT Programmer]

Great article, Fitz, as usual. Couple points, however. First, I don't see the dollar strengthening in the medium to long term. Asian countries have runaway inflation currently, and the only way they'll be able to reign that in is to raise rates. They've been doing this, but only tepidly. They'll get to the point where they have to drastically raise them. China will after the Olympics. Europe is starting to slow a bit, but the ECB unlike the Fed has a primary directive to fight inflation, not promote growth, and theirs is on the rise. So I see them raising rates soon, although not as fast as Asia will need to raise them. You won't see the Fed raising rates in the next year as they continue to worry about slow growth and not technically hitting the "R" word. All of this is going to further weigh on the dollar. Like you said, we've seen a slight strengthening of the dollar by a meek 3% --- you can compare that to a bear rally.

Ag is facing the same thing as oil. It has dropped off a cliff lately (I've seen a 200% return reduced to a 125% return on one of my fertilizer stocks --- I know, boo hoo for me). You've had tons of money poured into energy, ag, metals, etc. over the last 6-12 months because everything else was tanking. Now you've got people taking profits and looking for other opportunities to put their money to work. Cramer called the bottom last week, and true or not, you can't argue that in many people's minds we have turned a corner and it is at least flat if not up from here for the market in general. I'm still long on oil, NG, ag, and metals. 2-10% demand destruction in the short term is just that --- short term. Too bad the Fed can't print oil. Man, that would solve everything. ;-)

By the way, there's a sale on solar stocks currently. I picked up LDK recently, but they're just one of many that have come down in price and have low forward PE's and good prospects.

2008 Aug 06 09:23 AM

[Michael Fitzsimmons]

Thanks for the great comments. As usual, I like to jump in and add my two-cents-worth:

Ishortyou: i will assume your comment is sarcastic in nature...

redbaron, truth: thanks!

CLH: i hope you are right about the US dollar's turnaround, but I kind of doubt it. yes, the dollar has rallied 3% or so in recent months, but it is still down ~3% for the year. what is the basis to be bullish on the US currency? bush doubled the US fiscal debt in a mere 8 years. the US government is bailing out Bear, Freddie, and Fannie by trading toxic debt for US treasuries. this is socialism for the rich wall streeters (or, as i believe, actually fascism). meanwhile, the FDIC has shot 15% of its wad on IndyMac, while there will probably be hundreds of banks which will go under as the financial crisis plays out. meanwhile, the Fed can't hike interest rates because the economy and employment is so anemic. how does that lead to a strong US dollar turnaround? i believe the opposite, that it will continue to weaken until we get "leaders" in washington, and i don't see either obama or mccain as "leader" material.

Fedman: yes there has been a big price movement in oil, but as the article states i dont see big supply/demand fundamental changes. yes, there is more investment, but as the last few years' data shows, oil exploration spending is increasing drastically just to keep up with existing major oil fields' depletion rates. that is why i still maintain oil service stocks are the single best investment idea for the coming decade.

jjason: sorry, i don't buy the speculators argument for why oil prices are where they are. they certainly are part of the reason, but the reason they jumped into oil as an investment was two-fold: supply/demand fundamentals, and a place to hedge against the weak dollar policies of the Bush administration.

CT: i agree with you on the dollar (see my above comment to CLH). also, i'm not sure it's time to bail on ag and commodities. i recently bought more DBC as a hedge here. it all has to do with the US dollar and supply/demand fundamentals. i remember hearing the CEO of pepsi talk about how billions in india and china are going from one meal a day to two meals a day. that's alot of food...meanwhile, the idiotic ethanol mandates are causing huge distortions in the food chain. time will tell...

2008 Aug 06 09:46 AM

[lewisabroad]

oil demand is highly ineslastic - that's why it took a doubling in price to cause a 3% reduction in demand in the US. Oil is worth whatever people will pay for it - where jjason $60 comes from is beyond me. It costs ~$3 a barrel to extract oil in Saudi Arabia or Iraq, $40+ to extract it from Athabasca tar sands. add in transportation and delivery probably jjason is right, but it is willingness to pay that sets the price - not production and delivery costs. Clearly a fraction of drivers in the US are not coping well with $4 a gallon hence the drop in demand and price. Combine that with a reduction in Chinese subsidies and you have demand destruction causing a slight excess in supply that results in a radical drop in price. That's how inelastic goods' prices behave in a market. The true speculators in this market are all those American drivers willing to pay $4 a gallon - not traders on wall street. Complain about the price, but until you trade in your f150 or H2 for a prius you aren't sending a signal to the market that the price is too high.
One way we get $60 a barrel oil is with price caps. Do you remember last time we did that? lines at gas stations? theother way is demand destruction on a much bigger scale than currently. remember the late '90's when gas got so cheap? This was due to heavy demand destruciton in asia due to the asian financial crisis combined witha bunch of new investments coming on line from 10 years prior.

Michael is right on the money with this one. A host of fundamentals points to a long term price rise in oil. Until several of the fundamentals in demand change (US energy policy and foreign subsidies being 2 big ones) there won't be any structural change. What we are seeing is the radical effect that a few percentage points demand reduction globally is causing on oil prices. The only thing anyone could accurately predict in this kind of market is volatility. The hardest part is going to be finding the lows. Long-term, the price is going to go up, but there are going to be a lot of retrenchments and bumps in the road as demand fluctuates. Production is pretty well tapped out globally - anyone who tells you that we haven't hit peak oil from a production standpoint is not looking at production data.
As for US energy policy, the only bit that is going to make a difference to the typical American as well as the balance sheet is programs that help with demand destruciton. That means increases to CAFE, tax breaks on plug-in hybrids and alt-fuel vehicles like those running on nat gas, and a gradually increasing tax on oil imports to fund those programs. The tax revenue would go directly to programs designed to reduce demand by small business owners and homeowners, like rebates for PHEV and replacement of oil -burning furnaces with efficient gas / heat pump / solar thermal systems. Any excess would be nice to bring down the defecit - another big drag on our economy paying interest to Japanese and Chinese treasury holders.

Offshore drilling would also help, but is a longer-term solution versus demand reduction schemes and delays the inevitable point at which we wean transport from gasoline.

Long-term, the best investment play is hold what you've got in this sector. Short term, we won't know if this is a bottom until we see how much demand has been affected by the decrease in price - some time in September. I expect prices to slide until we see an uptick in US demand or reduction of inventory.

2008 Aug 06 09:51 AM

[John Pseudonym]

When every site I hit said gold was going to $2000 an ounce, I knew it was over.

Go with the crowds folks; get in, make money and get out before it's over.

Crowds don't think rationally, so don't argue with them...just go along and make as much as possible.

2008 Aug 06 10:02 AM

[longoil]

The lack of a long term energy policy is why I am long on oil, in particular with companies involved in E & P as oil well + drilling services. Even if significant measures regarding conservation, alternative energy and new reserves were implemented today you will not see noticable changes in oil prices for the next 5-10 years. The fact there is so much inaction extends the oil investment opportunity into the next 20 to 30 years.

2008 Aug 06 10:12 AM

[CT Programmer]

I hope I didn't sound like I was saying it was time to bail on ag and oil. Quite the opposite. The time to bail was a month ago, and that just to buy back in now at the lower price if you had the foresight. Ditto on metals. This is all just a temporary sell-off. Ethanol production accounts for less than 2% of the worldwide harvest. Ag, like oil, has gone up due to fundamentals. More mouths to feed, and to do that it takes better better ag tech --- thus fertilizer, seeds, tractors, etc. all are good plays long-term. Fertilizer contracts just keep going up and up. Last year potash went from roughly $500/ton to $1000/ton. Agrium just reported today and their revenues are up 90% yoy. Sure, that's not sustainable. And yes, the upward pressure for ag stock prices will EASE due to money being pulled out and directed elsewhere, but like oil, fundamentals are fundamentals and you can expect it to keep trending upward. If you're not into ag, today is the day to do it. Ditto for oil, NG, solar, wind and metals. They've pulled back from being overvalued, but that doesn't mean they're not solid investments.

I do agree with lewisabroad in that demand will taper off, but I see that as more just leveling off as the developed world uses less and the developing world uses more. Demand will still increase, but not by as much. However, you'll still have falling supply and increasing demand so prices will trend up over the long haul.

Also, even if we did have real "leaders" in Washington, these things take time. We're talking decades, even if a real plan was adopted today. So we're not coming off our oil addiction anytime soon, and China and Asia would lag behind us by a decade as well.

2008 Aug 06 11:06 AM

[Fedman]

Thanks for your response. I believe that Oil and NG are great plays for the next decade. My comments were focused on this particular point in time being an "entry point". That makes it more short-term in horizon. If we're looking 10 years out, then 147 oil is an entry point IMO. But I do think near-term we'll see better entry points.

I agree with you fundamental points, mine was just about equilibrium. Great comments by many of the posters here!!!

2008 Aug 06 12:13 PM

[John Pseudonym]

OMG! Just looked at the COP chart and it is a screaming sell!

The top has passed. Sell now. Good chance of $60 a share over the next few months.

That chart just screams major top in place. If you want to trade it, short term in/out is the only way to go.

2008 Aug 06 12:46 PM

[nakedjaybird]

T. Boone for President. Even tho he's half right by wanting to replace NG electrical power generation with WIND POWER and half wrong by wanting to burn NG in vehicles instead of biofuels, he understands the real problems; the real causes; and addresses the real actions that change the causes of the problems. His head is where the sun shines and wind blows, as contrasted to ALL THE LEADERSHIP IN WASHINGTON.

2008 Aug 06 12:52 PM

[Jimbo]

I have been investing energy since 1980. Investors seem to be like a herd of Wildebeastes(spelling?... panicking at the first smell of a lion. The fundamental issues on energy are still in place and aren't going to change as long as the "Greenies" are able to control the Democrats and many Republicans. Bill Clinton vetoed a Republican resolution authorizing drilling in ANWAR in 1996, saying it would be ten years until any gas or oil was produced.Well, here we are 12 years later and the "DemoGreenies" are still singing the same song.The Greenies want to bomb us back to the Stone Age, or at least the 17th. Century when all people and goods moved by wind, animal power or foot power. I have a solar water heater that has been saving me $50.00 a month in electricity since 2002. I am perfectly willing to embrace solar, wind, and all other alternatives. But we have to get from here to that great day with an intelligent energy policy. The Greenies don't want us to use "dirty oil" from the Canadian tar sands. They don't seem to understand if they get their way, we will be facing anarchy and revolution. When Green Peace first came out, I was an early contributor. Then I read their material and concluded they were NUTS!. We need more realists in Washington rather than utopians. I don't know how you accomplish that as long as politicians can use public money to buy votes. In the meantime, Those dirty,greedy oil companies ain't going away!!

2008 Aug 06 01:29 PM

[phdinsuntanning]

well, the Chinese dont like to expend their money in expensive commodities, the Japanese are sacrified to the God of Cheap Yen
and Growing Exports, Trichet is right but alone, and the strong dollar
will make some votes for GOP and XOM, they rule the world.

2008 Aug 06 02:40 PM

[AlexS]

There are at least three good reasons high oil prices aren't necessarily good for big oil (XOM, COP, etc) and falling oil prices (within limits) not necessarily bad. One is that higher prices get the public and the politicians riled up, and little good comes from politicians getting riled up (or pretending to get riled up). Two is that crude oil is the major cost input for refined products, and most big oil companies refine much more oil (1.5-2x) than they produce. Three is that high oil prices put in motion a lot more oil production projects and bidding for resources (engineering, materials, etc) makes everything get expensive. For instance, much has been made of offshore U.S. drilling, but even if Congress were to approve drilling, most of the deep water platforms are currently off the Brazil coast and it would be very expensive to snare them for OCS US drilling. Of course, few of our politicians would know that, because few of them have ever been responsible for any business outside of perhaps being a partner in a law firm. Sad to say both of our Presidential nominees fit the "no business experience" class.

2008 Aug 06 03:05 PM