The Rise and Fall of Oil: Roach Motel Theory

Includes: USO, XOM
by: Philip Davis

We all know how a roach motel works: Yummy food is placed inside an innocent looking box and the roach climbs in, finds some other roaches chowing down, and they all talk sports and politics and eat yummy stuff and have a good old time -- until one of them tries to leave. Then they realize the door really doesn't go both ways or, in the meaner models, they find out that sticky floor isn't just spilled beer -- it's glue!

Now the difference between roaches and fund managers is that a roach, finding himself hopelessly trapped in a position he can't get out of, is unlikely to go on TV to tell other roaches how great it is in there to entice them all to join in on the slim hope that he can gnaw his own legs off and crawl out over the suckers as they fall into the trap with him.

No, roaches have principles!

When I first started to write this article we were talking in comments and I mentioned that there had to be close to $1T in speculative money in the energy sector. Well I must have really pulled that number our of my butt as it turns out I was way off...

Major Integrated Oil & Gas alone has a market cap of $1.53T with just 11 companies in the group including ExxonMobil Corp. (NYSE:XOM), Total S.A. (NYSE:TOT), BP PLC (NYSE:BP), PetroChina Co. Ltd. (NYSE:PTR), Chevron Corp. (NYSE:CVX) and ConocoPhillips (NYSE:COP). This group has doubled since 2004, a $760B gain!

Independent Oil and Gas has over 100 companies with a market cap of $472B and top dogs include China Petroleum & Chemical Corp. (NYSE:SNP), Occidental Petroleum Corp. (NYSE:OXY), EnCana Corp. (NYSE:ECA), CNOOC Ltd. (NYSE:CEO), Suncor Energy Inc. (NYSE:SU), Devon Energy Corp. (NYSE:DVN) and Canadian Natural Resource Ltd. (NYSE:CNQ). CNQ is up 500% since 2004 while the rest of the group is up "just" 200% for a $311B gain.

Oil and Gas Refining & Marketing has a market cap of $412B among 50 members. Royal Dutch Shell (NYSE:RDS.A), Valero Energy Corp. (NYSE:VLO), Imperial Oil Ltd. (NYSEMKT:IMO) and Marathon Oil Corp. (NYSE:MRO) are the biggest companies in the group. The sector is up roughly 200% in 2 years, a $280B gain.

Oil and Gas Drilling and Exploration has a market cap of $328B with close to 100 companies. Petroleo Brasileiro S.A. (NYSE:PBR), Statoil ASA (STO), Norsk Hydro ASA (NHY), Transocean Inc. (NYSE:RIG), YPF Sociedad Anonima (NYSE:YPF) and GlobalSantaFe Corp. (NYSE:GSF) lead the pack. This sector is a mixed bag but up about 200% since 2004, a $216B gain.

Oil and Gas Equipment and Services has a market cap of $227B and 80 members. Schlumberger Ltd. (NYSE:SLB), Halliburton Co. (NYSE:HAL), Baker Hughes Inc. (BHI), Weatherford International Ltd. (NYSE:WFT), National Oilwell Varco Inc. (NYSE:NOV), BJ Services Company (BJS) and Smith International Inc. (SII) are the bigger names. The group has doubled in 2 years for a $110B gain.

Oil and Gas Pipelines bring up the rear with a $89B cap and just 30 companies. Williams Companies Inc. (NYSE:WMB), Enbridge Inc. (NYSE:ENB), Kinder Morgan Energy Partners LP (NYSE:KMP), El Paso Corp. (EP) and Energy Transfer Partners L.P. (NYSE:ETP) are the leaders. This group is up "just" 50% in 2 years because the fact-of-the-matter is we don't actually consume any more oil than we did in 2004. Still, that's a nice $45B gain in value! The fact that earnings at WMB are actually lower than 2004 doesn't seem to stop people from buying their shares because, after all, it does have something to do with oil!

So it seems I was way off, as actually $1.722T has gone into energy shares since 2004, more money than had gone into these companies in the previous 140 years of trading by a factor of 2 -- that's one crowded motel!

As Black Flag will tell you, it's easy to check into one of these energy stocks, all you need is blind faith that 140 years worth of investors before you have drastically undervalued virtually every single company in the sector by 70% while you have cleverly ascertained that this is the horse you are going to hitch your wagon of cash to.

Checking out, on the other hand, represents a large problem:

Exxon 5-year Weekly Chart 23 10 06We'll use XOM as a convenient example, as it represents 10% of the total sector, and is the most heavily traded of all the groups.

Exxon has a $413B market cap, trading at $69 a share, up from $35 in November 2003. Every day 20M shares of XOM are traded with $1.3B of shares bought and sold. Over the course of 1,000 days since Jan 2003, buyers have outnumbered sellers to the tune of $200B!

As we said, it's easy to get in...

Don't feel too bad though for energy traders; the smart money has already moved out of this sector and into the industrials (and virtually every other stock), as it seems like oil's reign-of-terror may finally be drawing to a close. Those guys have had almost 2 full years to make a graceful exit with 50-100% profits as fresh money poured into the ever-expanding energy market. Now we play the real game of Survivor!

After rising from $35 in Nov '03 to $64 in Feb '05, XOM's stock pretty much bounced around between $55 and $65 for the past 18 months.

During this time, the second group of traders, the ones that had happily taken the place of the first group that had already come in and eaten most of the yummy food, employed the strategy that roaches would never: In order to save themselves, the second group of traders went on television telling all the other roaches how great it was inside the trap and how the yummy food and good times would never end.

They said there were terrorists outside, insatiable Chinese demand, hurricanes, declining supplies, cartels, war! In short, they did anything they possibly could to entice another round of roaches to enter the trap, and, when they got you stuck in the glue, these charming guys would then promptly gnaw their own leg off and crawl over your now trapped investment in order to secure their own freedom.

Like any good mammal, it takes you a while to decide the situation is so dire you need to gnaw your own leg off, and you "only" spent $70 for your XOM shares so $65 doesn't seem too bad -- certainly nothing to panic over...

That is how $1.3B worth of money can escape the Exxon Roach motel every day. That translates to about $13B out of a $4T sector that can find its way to daylight on a daily basis. As long as they can pull in another round of "savvy investors" at 40% over Oct '04 prices, when oil was a whopping $55 a barrel (up from $30 the previous year), everything will be fine!

But what happens when new investors are unable to appreciate the value of the energy sector? What happens when it's just you, $4T worth of paper, no more yummy food and lots of glue?

Since it would take 307 days of normal trading for everyone currently in the Energy Motel to check out (assuming they find new "guests" to check in at the prevailing rates) you can expect that some traders may be a little more anxious to leave than others and may end up offering slightly lower rates to new entrants.

What's worse (if you are a newer buyer) is that only in the past 100 days has XOM traded consistently higher than $60 so the basis of those sellers is quite a bit lower than yours.

If they already sold half their shares at $65-70 since July, or if their basis is much lower as they've been in energy a very long time, they can afford to get out at $50-$55 with no loss at all. Following GATG (Generally Accepted Trader Guidelines), they are likely to want to get out with no more than an 8% retracement, so we can expect a whole lot of leg gnawing at around $64!

Needless to say I am short on XOM as well as many other energy trades; we don't know precisely when the hammer will fall, but when it does there are going to be a lot of broken toes!

For brevity's sake, I confined this discussion to the energy sector, but a lot of these symptoms can be seen across all commodities but none so egregiously as it is with the oil plays.

Read all of Phil Davis's articles on Seeking Alpha.