Oil Stocks Are Cheap, But Will It Last?

The price of crude oil dropped again today to rest at a 13-month low of $74, and this represents a 50% fall from the peak price of just under $148 only three months ago. The declining price has been mostly attributed to slumping demand from a stumbling global marketplace. Let’s think back to 3 months ago and you will surely remember that the price of oil and more specifically the price at the pump was the number one topic of conversation. The reason being that as everyone now realizes, oil is the lifeblood of our economy and when it gets expensive the effects are felt by everyone. Granted a lot has happened in the last three months and financial markets are extremely volatile, but often times volatility can create opportunity.

EnergyMany investors surely noticed that the energy and basic materials sectors were down more than 14% Wednesday, and the question that must be asked is “what is the true price of oil?”. That is a tremendously complex question with factors both economic and geopolitical, but it’s in our DNA at Ockham to try to break it down to what is important and actionable. Remember when crude first crossed over $100 per barrel, we wrote (Relief at the Pump: Don’t Hold Your Breath) that it would be a while before consumers and the economy would get a break from expensive oil. Well, now eight months later after substantial price appreciation, the oil bubble has burst, which is a blessing because I shudder to think what this credit crisis mess would be with the added impact of record high oil, can you say stagflation?

XOMWe invite you to look at a great article from The Wall Street Journal (Crude Counting: How Much Should Oil Really Cost?), in it the author inserts some valuable metrics by which to judge the current oil futures market. From the WSJ, “For the last 40 years, oil has represented more or less 2.5% of global GDP, Deutsche Bank says. That should peg oil today at about $59 a barrel.” This is a reasonable assumption that oil would tend to revert to its historical average price. However, as the article later points out, oil that is cheap to produce is become more and more scarce, and that some oil these days costs as much as $80 per barrel to produce. Clearly, oil producers will not produce oil that will not make them money, and the laws of supply and demand will take over from there. If crude is being sold too cheaply on the international marketplace, supply will shrink and cause an increase in price. By this line of reasoning, the price of oil at $74 is already pretty cheap and a drop from here just means that the most expensive production projects will get put on hold.

CVXSo, the economic side of the equation seems to suggest that the global demand slowdown would need to be very significant in order to justify the price dropping too much further, what about the geopolitical side? We cannot foretell what will happen in the future that might create a supply shock—be it war, political unrest, or terrorist activities—so we will not get into that can of worms. However, we can formulate a calculated guess as to the behavior of OPEC in its upcoming meetings (Nov 18th). Rest assured, OPEC will want to do all it can to drive up the price of oil to line their countries’ coffers with oil money. So, the odds of OPEC cutting production are quite good which suggests yet again, that cheap oil is a thing of the past. Interestingly, OPEC member countries will be in an interesting position similar to that classic game theory example of the prisoner’s dilemma. While all member countries have an interest in proclaiming to the world that the cartel members are collectively cutting production, but it is to their advantage to cheat the other members by selling more than they were allotted. Keep that in mind, when OPEC’s likely announcement comes in November.

HKSo, it seems reasonable to us that the price of oil has overcorrected after the commodity bubble’s burst. These most basic of factors discussed above, lead us to believe that for the price of oil to slip too much further the global recession must be a major one to drop demand so drastically. If that indeed is the case, then no stock is safe and all bets are off. However, if that is not the case and the dip in global demand is shallow and brief that oil stocks will prove to be a nice investment right now.

RIGThere are undervalued stocks all over this market, but energy stocks could be quick to rebound when crude begins to rise. Some equities that interest us at present levels are Exxon (XOM), Chevron (CVX), Petrohawk (HK), and Transocean (RIG). We have attached throughout this piece the ratings history charts for each of these securities, and each one of them falls into our Greatly Undervalued rating at present levels. No one can know what the “true” or intrinsic price of oil is but you must take the data and try to identify a trend.

About Ockham Research 645 Articles

Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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