Oil stocks cheap enough yet?

From Bloomberg (June 22nd): “Crude for August delivery on the New York Mercantile Exchange fell as much as 93 cents to $93.24 a barrel in electronic trading and was at $93.65 at 1:35 p.m. London time. The contract yesterday climbed 54 cents to $94.17. Futures have risen 21 percent in the past year. Brent oil for August delivery was at $110.84 a barrel, down 11 cents, on the London-based ICE Futures Europe exchange. The European benchmark contract traded at a premium of $17.19 a barrel to U.S. futures. The difference between front-month contracts in London and New York reached a record close of $22.29 on June 15.”

So we have a huge (record) spread between oil prices in Europe and the U.S., which I cannot explain but would guess might have something to do with storage or inventory levels – if you have a more precise explanation please leave a comment. I find it remarkable that crude oil prices in the U.S. are still hovering around the $93 to $95 level. The slowdown (which I was expecting back in March/April and is now old news) has caused a significant rise in crude inventory levels and taken the steam out of the energy stocks.

I’m reluctant to be simplistic, but most analysis is simple. Note that crude inventories began to decline (as usual) between September and December of 2010, from a very high level and with a very steep rate of decline. The rebounding economy was hungry for fuel.

News from September 30th, 2010: New York—Nymex crude slumped $2.78 to settle at $71.92/barrel August 31, driven lower by a weak expiration in product markets and a down turn in equities late in the session.”

By December 30th of 2010, the price had risen to $91.38 or 27% (a substantial lift over just three months). Crude inventories plummeted during the final quarter of 2010 and oil prices rocketed up. That’s how it’s supposed to work.

Why has the price managed to hold up despite the rebuild in inventories? After all during the recession years as crude in storage ballooned the price got too much more reasonable (for we consumers) levels: for example at Dec. 31st 2008 it was $44.69. I filled up my 60 (+ or -) litre gas tank last week and it cost me a WHOPPING $80. No wonder the hotel companies are slashing room prices and advertising the lower rates in full page advertisements. And if that seems like a painfully large amount of money for a tank of gas, imagine those sorry folks in Europe?

The price of crude (and gasoline) should be lower, and to bet against this right now in my opinion is just not prudent. Strangely enough, the stocks seem to be discounting a lower ‘future’ price already. Back in March, I included this chart for Suncor, with a warning that it would be wise to reduce one’s commitment to the energy sector.

Since that time, many energy stocks have had a bit of a tumble even if the price of crude has not followed suit. Circumstances like this seem to defy logic, but nobody said markets are logical – the emotional element is always a wild card.

The FOMC meeting confirmed that the U.S. government is lowering its expectations for the economy, and experts believe interest rates will have to remain remain lower for longer. If the economy will remain in the doldrums, with no imminent prospect for job growth then who’s going to rush to the service station for more $80 refills? This bleak outlook (and big deficits as discussed in this blog at length in the past) is why there’s been no hurry to increase interest rates and has firmly thrown inflation worries into the back seat:

So far, the concern about the deficit hasn’t driven U.S. borrowing costs to above-average levels. The yield on the benchmark 10-year Treasury note was 2.98 percent at 1:40 p.m. in New York today. That’s below the average of 7 percent since 1980 and the average of 5.48 percent in the 1998 through 2001 period, according to Bloomberg Bond Trader. Treasury six-month bill rates were at 0.08 percent.”

So we can assume that it’s deteriorating investor expectations concerning economic growth and how it WILL negatively impact the energy sector that has done the damage to Suncor shares, pictured in this recent chart.

Confusing things more, is the huge profit margin I expect downstream companies (those with service stations) must be earning – $1.25 per litre in Toronto has got to be a cash cow at the pump. Where am I going with this?

#1) The U.S. is our biggest customer for energy, evident from this exhibit from their Energy Department. Based on the inventory data above, I’d say at the moment our biggest customer has more than enough crude in storage at least for a few months.

#2) There’s a huge risk the oil price is inflated for reasons having nothing to do with fundamentals.

#3) Oil companies with retail distribution are making a killing.

In the event that the consensus is wrong – the U.S. and European economies are about to enjoy explosive growth – the integrated energy companies (like Suncor) are the ones to own if you just have to own something in the sector as insurance. A possible drop in valuations should crude prices fall will be offset by the windfall they’ve been raking in at the pumps.

As for exploration and upstream companies…..the evidence suggests it may just be too early to back up the truck.

ONE UGLY FELLOW

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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One Response to Oil stocks cheap enough yet?

  1. alex says:

    Awesome information! I do love the way you have presented this specific issue.

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