Oil Prices Today Are Complete Nonsense, Get Ready For Wall's Street's Springboard

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Includes: BGR, BNO, CRAK, DBO, DDG, DIG, DNO, DRIP, DTO, DUG, ERX, ERY, FENY, FIF, FXN, GUSH, IEO, IYE, NDP, OIH, OIL, OLEM, OLO, PXE, PXJ, RYE, SCO, SZO, UCO, USL, USO, VDE, XLE, XOP
by: Open Square Capital

Summary

Wall Street's forecasted oil price decks will soon be below current strip prices.

Oil price decks are too low given current inventory levels.

When banks inevitably adjust their price decks, E&P corporate earnings and ratings will be revised higher, lending a boost to sentiment.

Take a look at this.

This is the consensus Wall Street estimate for where oil prices should in the next few quarters. We've argued that it's wrong, and that it'll likely be much higher in the coming months. Despite the recent run-up, the euphoria is completely premature. Oil prices today at $57/barrel for WTI are still complete nonsense. For the vast majority of producers it's unprofitable on a full-cycle basis, and it's only becoming obvious for the investment community.

In the past few weeks, we've already seen oil prices begin adjusting to the reality that inventory levels are declining, and many of those tiny dots are already below today's levels (spot and strip). While oil stocks haven't fully recovered yet, we think that's just a matter of time before "the gap" is closed. What gap you say? This gap:

The underperformance of oil stocks to the actual commodity itself. You'd think this would track closely as oil companies produce oil, but this year that link has been tenuous at best. We believe though that gap will inevitably be filled (i.e., read: oil stocks will go up), and that gap will be filled by a few things:

  1. Shorts covering - particularly in the most aggressively shorted oil companies (e.g., California Resources Corporation's short interest is +35% of shares outstanding)
  2. Investors forecasting/expecting higher cash flow generations, which in turn means higher valuations
  3. Revised analyst estimates (i.e., increasing hype)

Let's talk about that hype for a bit. Wall Street analyst sell-side reports aren't something we typically take much stock in. Do we read them? Yes, but we read them for purposes of understanding what the consensus is thinking, and to see if we can use them as a de facto "Red Team" to punch holes in our own thesis. It's always better to know your counterparties' arguments better than they know it themselves, so it's part of our diligence process.

We know that while most buy-side participants claim they don't follow the reports, they are influenced by them. How do we know that? Well we talk to them, and often the reasons given for not investing in oil at these low levels is because "everyone knows the shale band will prevent oil from going higher". Fair enough.

What's important about the Wall Street oil price estimates above is that they affect the earnings estimates of the E&P companies these banks cover. Makes sense, if your oil price forecast is X, you'd use X to model out the research reports for the oil companies you analyze. Unfortunately, if your oil/gas price deck is artificially low, guess what? Your equity team, which uses that price deck to calculate corporate earnings, will also publish artificially low earnings/cash flows and price targets.

So guess what happens when companies begin reporting results that exceed analyst estimates? You guessed it . . . beat expectations, which then leads to a slew of mea culpas, revised estimates, and rising price targets and ratings (okay maybe not the mea culpas).

Outperformance ratings will begin raining down from the banks, showering our E&P companies. Now if we were cynical, we'd think that this was really a game, a game where investment banks are intentionally doing this so that when those revised ratings occur it helps them generate more banking fees because it's easier to help companies raise more capital (debt or equity) when there's hype. Yet this would presuppose that the earlier lower oil deck was a ruse, that it wasn't because they were founded on flawed analysis/logic.

So which is it? An elaborate game planned by Wall Street, or flawed thinking that unnecessarily exacerbated the declines, but when reversed will springboard the euphoria? We think the latter ... which means, don't be surprised when Wall Street shows up at the party in a few months to take it to another level. For now, if oil inventories continue shrinking, sit back and watch oil prices, and Wall Street's newfound euphoria fly.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.