Oil & Gas Stocks: Is The Sell-Off A Reaction To Old News?

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Includes: OIL, USO
by: Richard Zeits

Summary

The latest U.S. petroleum inventory data shows “mustard seeds” of improvement (even though a trend confirmation from the next few reports is needed).

The current crude oil price can be interpreted as a “pain shock” signal needed to cause a supply response.

The period of extremely low prices is likely short-lived.

The article provides inventory data analysis on a normalized basis.

IMPORTANT NOTE: This article is not an investment recommendation or research report. It is not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the Disclaimer at the end of this article.

The price of oil dropped sharply yesterday in response to EIA's weekly petroleum report that showed a strong crude oil inventory build, offset in part by declines in gasoline and distillate stocks.

(Source: Zeits Energy Analytics, January 2015)

The inventories report indicated continued oversupply. However, based on my review, the data represents an incremental improvement from previous reports and gives some hope that the supply situation may be slowly moving towards an inflection point.

Petroleum inventories data can be difficult to analyze due to its multiple components and week-to-week volatility. Most importantly, data cannot be interpreted correctly without taking into account the demand seasonality. The following analysis attempts to unmask relevant trends in the data.

Crude Inventories Show A Big Build, But Do Not Tell The Entire Story

The following graph shows the trend in the U.S. commercial crude inventory growth after adjusting for seasonality. The pace of the build has remained brisk in the past two months, exceeding the pace of the build during the preceding five months by ~0.7 million barrels a day.

(Source: Zeits Energy Analytics, January 2015)

While the market remains oversupplied, it is important to interpret the latest crude inventory data points in conjunction with the refinery utilization data.

Product Inventories: Incremental Improvement

Inventory data for the largest product categories - motor gasoline and distillate - show a decline in the seasonally-adjusted pace of growth, which reflects reduced refinery runs and explains why the increases in crude oil stocks in the past few weeks are not as bad as they might appear.

(Source: Zeits Energy Analytics, January 2015)

(Source: Zeits Energy Analytics, January 2015)

Aggregate commercial petroleum stocks data provides a more complete view of the petroleum supply/demand balance as it effectively eliminates the noise associated with refinery utilization variability.

The graph below shows the trajectory of the U.S. total petroleum inventory surplus relative to the 5-year average. On a seasonally-adjusted basis, aggregate petroleum inventory grew by ~1.1 million barrels per day faster over the past two months than over the preceding five months. As of January 23, 2015, aggregate petroleum inventories exceeded the five-year average for this time of year by ~100 million barrels.

While the oversupply remains significant, the graph also reveals that the trajectory of inventory build began to flatten in the past few weeks.

(Source: Zeits Energy Analytics, January 2015)

Could this flattening in the pace of aggregate inventory build indicate that the price signal is finally causing a supply response (various producers voluntarily reducing production)? Could an inflection point be approaching? Another few confirmation data points would be needed to reach a definitive conclusion, particularly given that oil spends several weeks in cargoes before it reaches storage.

If the supply response has indeed started to occur, it will likely be sustainable, given the magnitude of the price drop and the natural delay in the industry's reaction. Once early signs of improvement emerge, the oil price reaction can be quite strong, as the perception is likely to be that the corrective mechanism has already been set in motion and the strong price signal is no longer needed. The oversupply at some point will be replaced with undersupply.

Does The Sell-off In Oil & Gas Stocks Reflect Old News?

Yesterday's inventory report triggered a vigorous sell-off among oil & gas stocks. Many large-capitalization E&P independents declined 5%-10% yesterday and continue to decline toady. The following are some examples of yesterday's declines:

  • LINN Energy (LINE): -10%
  • Whiting Petroleum (NYSE:WLL): -9%
  • Continental Resources (NYSE:CLR): -7%
  • Marathon Oil (NYSE:MRO): -5%
  • Devon Energy (NYSE:DVN): -6%
  • Encana (NYSE:ECA): -7%
  • Pioneer Natural Resources (NYSE:PXD): -7%

Small- and mid-capitalization oil & gas stocks fared even worse, with a significant number of names declining 10%+ yesterday and trading sharply lower today:

  • Bill Barrett (BBG): -17%
  • Laredo Petroleum (NYSE:LPI): -9%
  • Breitburn Energy (BBEP): -11%
  • Comstock Resources (NYSE:CRK): -11%
  • SandRidge Energy (NYSE:SD): -10%
  • Approach Resources (NASDAQ:AREX): -10%
  • Penn Virginia (PVA): -9%
  • SM Energy (NYSE:SM): -9%
  • Sanchez Energy (NYSE:SN): -8%

The sell-off appears to ignore the incremental (albeit still to be confirmed in next reports) improvement in the petroleum supply/demand trend that is detectable in the latest two data releases.

The sell-off seems to be a reaction to what has been largely acknowledged by now in the market: in the absence of OPEC's production cut, the excess supply may have to be addressed via a "pain shock" price signal.

However, the extremely low price of oil is likely transitory and does not reflect the industry's longer-term fundamentals. Given the existing cost structure of the global supply, the industry would not be able to keep the market adequately supplied at $45 per barrel for long.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.