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Time to Sell Oil Stocks?

A CNNMoney article is warning investors that oil, and oil company stocks are overvalued:

Beware Big Oil stocks

“Nobody in his right mind thinks this oil price is sustainable or justified by market fundamentals,” said Fadel Gheit, a senior energy analyst at Oppenheimer. “The higher prices go, the greater the risk for downside potential.” Over the last month the price of U.S. crude on the New York Mercantile Exchange has surged nearly 20 percent, hitting a record high of $83.90 a barrel last week.

Yet the AMEX oil and gas index, which tracks both large and small U.S. oil companies as well as refiners and oil service firms, has risen just over 6 percent over the same time. The big integrated oil companies haven’t done much better. Exxon Mobil (Charts, Fortune 500) and ConocoPhillips (Charts, Fortune 500) are up about 8 percent, while Chevron (Charts, Fortune 500) has risen just over 6 percent.

I think oil prices have gotten a little ahead of themselves at this point, and I think they will correct some by the end of the year. In fact, in a recent story on Daily Kos that asked for predictions on the year end price of oil, my prediction was $73.50. But is oil outrageously overpriced, given the fundamentals? I don’t think so. And neither do some others. Returning to the CNN story:

Gheit said investors are betting oil prices won’t stay at their current record levels. His view is by no means unanimous across the industry. Many experts say a limited supply coupled with seemingly infinite new demand does justify oil prices above $80.

“With China and India growing the way they are, they’re just not going to go down,” said Harry Clark, whose firm Clark Capital Management has a buy rating on the whole energy sector. “$100 oil, it’s only a matter of when, not if.”

Gheit thinks the ride is over:

But Gheit seemed to think the sector may be played out. He pointed to the impressive growth the sector has seen over the last five years – crude prices along with shares of Exxon, Conoco and Chevron have roughly tripled during that time. “A lot of people say energy has already exceeded the wildest expectations,” he said. “If oil prices come down, you’re going to see total migration out of the sector” and into things like technology, which has lagged the broader market for the last several years.

I think Gheit is wrong about the fundamentals being completely out of whack. And he has been very wrong on oil prices in the past. From February 2007:

“If someone came up to me five years ago and said the price of oil was going to be above $40, I would have put them in a straitjacket because it seemed so unrealistic,” [Oppenheimer & Co. analyst Fadel] Gheit said. “Now, when oil starts moving down toward $50 barrel, we get excited and think it’s a great bargain.”

But he is correct that investors are betting that prices won’t stay high. Otherwise, oil company stocks would have kept better pace with the price of oil.

Oil company stock is currently valued as if crude cost $60 a barrel, according to Mark Gilman, a New York-based oil and gas analyst with the brokerage The Benchmark Co. But given what it costs to produce a barrel of crude and the amount of oil left in the ground, Gilman thinks even $60 is too high.

“You take out all the fluff and the fear and the speculation, and $35 to $40 is where the price of crude ultimately belongs,” he said. When asked if that could mean a halving of Big Oil share prices, he said that sounded about right.

That’s the bet, isn’t it? If you think oil prices will fall to $60, oil company stocks are priced about right. If you think it will fall to less than $60, then they are overpriced. But if you think oil prices will stay above $60, then oil company stocks are still undervalued. If you are in the “Peak Oil now” camp, then you may look at this one of two ways. One, oil prices may be going much higher, and you feel that oil company stocks will follow. On the other hand, you may think that with Peak Oil, oil companies are going to die a slow death and their stock should be avoided. Personally, I think they will morph more and more into energy companies over time, and high oil prices will give them the cash to move into other areas.

If you want to know why Gheit really thinks the sector is overvalued, here he is commenting last month:

Gheit says there’s plenty of oil out there, it just needs to get to a price where it’s profitable to extract. “We have so far consumed one trillion barrels” in all of history, he said, pointing to a 2000 study from the U.S. Geological Survey that made predictions based on rising prices, technology advances and assumed new discoveries based on past finds. “There are three trillion more to go.”

The former chairman of Shell, the IEA, and the NPC have all recently come out and endorsed the Peak Lite concept, in which demand is growing faster than supplies. This will place a lot of pressure on oil prices, even if there is oil left to be found. It doesn’t matter if the earth is a hollow sphere completely filled with oil if you can’t extract it fast enough to meet demand.

I don’t see anything on the horizon that leads me to believe that we will be oversupplied any time soon. We could go into recession, or there could be some surprise out there that destroys demand, but don’t expect to see a flood of new supply any time soon. A little, maybe. But not a lot.

Gheit has been on the wrong end of this oil price rise. But I think it was driven by some fundamental factors that he doesn’t seem to consider. For me, I am betting that oil prices stay above $60 for the long-term. And I will repeat something I have said before: I only invest for the long-term.

Disclosure: I do own oil company stock, for the long-term.

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October 2, 2007 - Posted by | Chevron, ConocoPhillips, ExxonMobil, investing, oil prices

7 Comments

  1. There may be three trillion barrels to go, but I sure hope we leave the last two in the ground.

    I’m not buying oil stocks. I’m buying railroad stocks. The only bet I’m making is that the steel on steel coefficient of rolling resistance will remain less than rubber on concrete.

    Comment by robert | October 2, 2007

  2. RR-
    You might want to sell the oil stocks, then buy back later.
    Thanks to thug states, we may have supply problems for years and years.
    But! Oil demand is not strong, and we may have seen Peak Demand this year for fossil crude. The average marginal cost of production worldwid is probably under $5 a barrel. And demand for fossil crude may be declining already at these prices. That is a dicey situation. A low-cot commodity at high prices, with demand falling.
    Another strategy you may like is to buy some puts on the NYMEX, well out of the money. Say, Dec. 2009 puts at $45-55.
    Obviously, if oil goes down, you make good money on your puts. If not, your oil stocks hold value.
    But, really, I can’t see oil stocks going up to much more from here. You had a great investment, but investing is all about rotating into the next asset class that does well. Plain old US blue chips were a great investment from 1982 through 1999 (so were some grwoth stocks). Since then, you want to be in Far East Asian stocks, or foreign markets in general, and oil.
    I think a next phase is coming. A rotation. Likely, oil can’t be great again. Chinese stocks are up 400 percent in last two years. I sense this rally in oil and foreign stocks may be drawing to a close (foreign stocks may have some legs left).
    I wish I knew which sector will rally next.
    US stocks? They have been cruddy since 1999. They were cruddy from 1967 through 1982. The Dow hit 1000 in 1967 and then again in 1982. You can wait 15 years for a market to recover. Look at Japan. Still down from 1980s highs.
    My real advice; Never sit an a sector forever, waiting for recovery. Show no loyalty, and rotate into best performing sectors. You have to be like a party girl: you love who pays you best and last.
    You had a great run in oil, but personal loyalty and investing sense are two different worlds.
    Think about where the next secular rally will be.
    You want to be roughly right rather than exactly wrong.

    Comment by Benjamin Cole | October 2, 2007

  3. Nah, look at the metric:

    [US Dollars] / [ Barrel of Oil]

    Your prediction for the price of oil is wrong, not because the price of oil has declined, but because the value of the US dollar has declined.

    Comment by Robert McLeod | October 2, 2007

  4. isn’t all this great dialogue!!

    THAT’S WHAT MAKES A MARKET.

    especially a commodity market.

    HOT DOG!

    Comment by Anonymous | October 2, 2007

  5. SELL HOT DOGS!
    BUY HAMBURGERS!

    Comment by robert | October 2, 2007

  6. Could it be that fundamentals have little to do with it? Might the price of oil not be a simple manifestation of supply and demand? If you look at the actual production history and demand forecasts for the past several years, the price would seem to be a pretty good indicator of a slowly tightening world market.

    In the end, we all know that the resource in the ground will only get more valuable as it depletes.
    Tom Atkins

    Comment by Tom | October 3, 2007

  7. Certainly there are many variables to consider in speculating how high (or low) the price of oil will go. But basically I agree that it won’t go lower than $60 before it rises again. Why? If the general consensus that “the easy oil has all been found” is correct, then oil companies will need to expend more money to extract the same barrel of oil, and they will have to charge more to get that money. If prices fall too far, the hard-to-get oil will become uneconomical to extract. That, of course, would also raise crude prices more. So either way you look at it, we are looking at a future of higher prices, with some ups and downs along the way. Barring some significant demand destruction, of course.

    Comment by Rice Farmer | October 3, 2007


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