Oil stocks have
to be one of the most unloved sectors in the markets today. The recent
general-stock-market and oil corrections combined with the
incredibly-negative psychology spawned by the BP oil spill have driven oil
stocks down to deeply-oversold levels. This swoon has also left this
sector very undervalued, a barren wasteland strewn with great bargains
for investors.
Valuations are
classically measured by price-to-earnings
ratios. P/E ratios reveal how much the markets are asking investors to
pay for each dollar of profits a company earns. The lower the P/E, the
cheaper the stock and the better the bargain. Buying a company at 7x
earnings, which means paying $7 for each $1 of annual profits, is a
far-superior deal to buying it at 28x earnings. It is much easier to achieve
the first half of the buy-low-sell-high stock-trading-success equation if
stocks are purchased at relatively-low P/Es.
Oil stocks
generally trade at lower multiples (P/E ratios) than the broader stock
markets. As the brutal stock panic ripped the markets to shreds in late 2008,
2007 was the last normal year before that epic discontinuity. The flagship
NYSE Arca Oil Index is probably the best metric to use to measure valuations
of oil stocks as a sector. Launched way back in August 1984 as the AMEX Oil
Index, this price-weighted index comprised of 13 elite oil majors is
considered the definitive measure of oil-stock performance.
Better known by
its XOI symbol, this index had an average month-end
market-capitalization-weighted-average P/E ratio of 12.3x in 2007. Meanwhile
the broader S&P 500 (SPX), which also includes the large American oil
stocks in the XOI, had a comparable average 2007 P/E of 20.2x. Thus the oil
stocks were trading at about a 39% discount to the general stock markets over
this 2007 baseline period.
At the end of
last month as oil stocks languished along with the general stocks, the XOI
sported an MCWA P/E ratio of 11.1x compared to the SPX's 17.7x. This discount
is only 37%, which is in line with pre-panic precedent and implies oil-stock
valuations were slightly ahead of 2007's average. Given this late-June
P/E-ratio comparison, how can oil stocks be considered undervalued today?
There are other
ways to gauge a sector's valuation beyond P/E ratios, and these are where oil
stocks look like a tremendous bargain. Oil stocks have two primary drivers,
the oil price and the state of the general stock markets. Each of these
drivers also offers an excellent alternative valuation metric, and these
really reveal the widespread extent of oil-stock undervaluation today.
Stock prices are
ultimately driven by profits, and oil-price gains naturally lead to leveraged
increases in profits for oil producers. The higher the average oil price, the
better the oil-stock profits, and hence the higher oil stocks will be bid by
investors. Rising oil prices also generate excitement for oil stocks among
traders, leading to increasing flows of capital into the oil-stock sector. So
oil's impact is obviously large.
But interestingly
the general stock markets are another major driver of oil stocks, often
eclipsing oil's own influence. I did a study
of XOI performance versus oil and the SPX a couple years ago that highlights
this crucial fact. The large oil stocks of the XOI are so massive, with so
much mainstream capital invested, that they mirror and often amplify
underlying moves in the general markets. Even when oil is strong, oil stocks
have a tough time rallying if the stock markets are weak.
Looking at oil
stocks relative to either of their primary drivers today really drives home
the great bargains to be found in this seriously-undervalued sector. The
easiest way to quantify the relationships between drivers and the stocks they
move is through ratio analysis. Ratios simply divide the sector driven (oil
stocks in this case) by its primary driver. The resulting number charted over
time reveals important tradable trends in relative strength and weakness.
We'll start with
the XOI/Oil Ratio, which is the daily close of the XOI oil-stock index
divided by the daily close in oil (benchmark West Texas Intermediate crude).
This ratio is rendered below in blue, superimposed over the raw XOI itself in
red. Compared to oil, oil stocks are definitely undervalued today. Odds are
high this valuation gap will close in the coming year, either by oil stocks
rallying or oil falling.
Thanks to the
stock panic and its aftermath, both the XOI and XOI/Oil Ratio (XOR) have been
on a wild ride over the past couple years. Driven by record oil prices in
early 2008, the XOI climbed to an all-time high of 1630 in May that year. Oil
averaged $125 that month, before topping itself a couple months later at an
astounding $146 per barrel. But as this ratio shows, oil stocks lagged oil's
terminal ascent.
The ratio hit a
low of 9.6x on the very day in July 2008 when oil topped. Just like today,
the ratio was far too low to be sustainable. Either oil stocks had to soar to
reflect the higher prevailing oil prices or oil had to correct so the low
oil-stock levels were justified. Back then, oil corrected as it should have.
This commodity was wildly overbought at the time, trading 40% above its
baseline 200-day moving average. For comparison the 2006 and 2007 average was
less than 7%, and in April 2010 it peaked under 17%.
As oil corrected
sharply (down 23% in the first 5 weeks) in the summer of 2008, oil stocks
followed it lower but weren't falling as fast as crude. Hence the ratio rose
in Q3'08. Then when the terrible stock panic hit, oil stocks plunged with the
SPX which again drove the ratio to unsustainable lows. But after the XOI
bottomed in late November, oil stocks started recovering fast. This
index's initial rally was a blistering 31% in less than 4 weeks! Since oil
was still drifting lower at the time, the XOR soared dramatically.
These
abnormally-high ratio readings persisted until oil bottomed near $34 in
February 2009. At that point oil started rallying significantly while the XOI
sold off with the SPX into the latter's infamous March 2009 despair lows.
Ever since, during the strong SPX cyclical bull that was born then, oil
stocks have been persistently lagging oil. While the giant XOI oil stocks
were advancing with the general markets, they weren't rallying as fast as oil
which inexorably drove the XOR lower.
The result is the
ratio downtrend rendered above. While the XOI managed to rally 49% at best
since its panic lows, crude oil has soared 152% higher at best out of its own
nadir. In the month before the SPX correction started in late April 2010, the
XOR averaged 13.2x. The XOI was closing at around 13x the price of crude oil.
This is actually on the low end of this chart, even if you ignore the
anomalous panic spike.
At oil stocks'
best levels relative to oil since last summer, the XOR ran 15.5x in September
2009. This week, thanks to the devastated sentiment in the wake of the SPX
and oil corrections and BP oil spill, the XOR was only trading at 12.3x. In
order for the XOI to return to similar levels relative to today's $76 oil
price, it would have to rally 26% from today's levels. But the extent of
oil-stock undervaluation relative to oil runs well beyond this comparison.
In all of 2006
and 2007, the last baseline normal years before 2008's wild panic volatility,
the XOR averaged 17.9x. The XOI tended to close around 18x the price of crude
oil. For the oil stocks to regain this historic relationship, the XOI would
have to surge 45% above today's levels! There is every reason to expect this
relationship to normalize, as oil stocks play such a crucial role in both the
world economy and investors' long-term portfolios. Capital simply has to
return to this unloved sector.
Now 26% to 45%
gains in elite oil stocks are certainly enticing, but these projections are
conservative on a couple key fronts. First, these are based off of oil prices
staying stable at today's $76. If oil continues rallying, as it is
highly likely to as this SPX cyclical bull regains steam, the XOI targets quickly
climb higher. Not only are higher oil prices plugged into the denominator of
the ratio, but strong oil rapidly multiplies investor interest and hence
capital inflows into oil stocks.
Second, smaller
oil stocks are likely to really amplify the baseline XOI gains. Remember that
the XOI oil stocks are the giants of the industry, majors with huge
market capitalizations that have stock-price inertia much like oil
supertankers. At the end of last month, the average market cap of the 13 XOI
component stocks was $75b compared to the average SPX component size of under
$20b. Smaller oil stocks have far greater potential to rally, and they could
easily double or triple the underlying XOI gains.
While the
undervaluation of oil stocks compared to oil is plenty compelling, even more
so is their chronic undervaluation compared to the broader stock markets. The
XOI/SPX Ratio (XSR) beautifully quantifies this. Incredibly, relative to the
general stock markets oil stocks were recently trading well under their panic
lows! There is probably no greater sector bargain today than these
beaten-down oil stocks.
Back in early
2008 as oil soared towards $146, oil stocks rapidly advanced far outpacing
the SPX gains. Of course the general stock markets were suffering in a new cyclical bear then, so the XOI's relative strength was
even more impressive. But once oil started correcting in July 2008, the oil
stocks fell way faster than the SPX. This trend accelerated during the stock
panic, when commodities stocks were hit disproportionately hard since
mainstream money managers consider them to be exceptionally risky.
While the XOI
bottomed in late November 2008 at the formal panic low, the SPX ground lower
into its despair lows in March 2009 on fears of the newly-elected Marxists
radically raising already-crushing taxes on American investors. The XOI
recovering faster than the SPX between November 2008 and March 2009 drove the
XSR higher again and oil stocks approached their best levels relative to the
general markets since the summer of 2008 when oil was so high.
But ever since
then, as the SPX cyclical bull powered higher, oil stocks have been falling
farther and farther behind the general markets. The ratio downtrend has been
relentless as you can see above, with the XOI massively lagging the SPX. When
the SPX topped before its recent correction in late April 2010, this ratio was
running 0.93x. This was not far above its panic lows of just under
0.89x. Even before the SPX corrected, oil stocks were almost as deeply out of
favor as they had been in the bowels of the panic!
And since that
correction started, oil stocks have again plunged disproportionately hard.
The SPX correction not only killed sentiment in general along with the
appetite for risk (and hence commodities stocks), but it drove a concurrent
sharp 20% correction in oil itself. With both of oil stocks' primary drivers down
sharply, the oil stocks didn't stand a chance. Despite already being very
cheap relative to the SPX in late April, they plunged even lower.
On top of this,
the Obama Administration inexplicably decided to demonize the entire oil
industry over a single blowout which a single oil company was responsible
for. It reminded me of kindergarten, when an inept socialist teacher punishes
her entire class for the misbehavior of a single child. As Washington
relentlessly attacked the critical oil industry as a whole, already-weak
oil-stock sentiment sunk even lower.
The result was a
mind-blowing disconnect between oil stocks and the broader stock markets. At
worst in early June, the XOI/SPX Ratio plummeted under 0.84x! This was well
under its panic lows, and the worst seen since March 2007 when oil was only
trading around $62. By that point in our recent correction, oil was back up
to $74 (almost 20% higher). Oil stocks were deeply oversold and incredibly undervalued.
Is this the new
normal, the relative value of oil stocks compared to oil and the SPX
continuing to shrink or remaining low forever? Almost certainly not. Oil
remains the lifeblood of the world economy. There is no commodity more
important. Without oil, nothing else could be transported and our whole
intricate global supply chain of everything physical including food would
collapse. The companies that produce this all-important cost-effective and
efficient portable energy source are going to remain great investments for
decades to come.
And oil prices
are almost certain to continue rising on balance too, farther increasing
oil-stock profitability and demand among investors. Half the world (Asia)
continues to rapidly industrialize, which necessitates massive increases in
per-capita oil consumption. Meanwhile new oil reserves, especially the
highly-prized light-sweet crude that is easy to refine, are getting harder
and harder to find. Companies like BP aren't drilling under a mile of water
because it is fun, but because large new oil reserves are almost never found
on land anymore. And when they rarely are, the oil is usually in
tough-to-produce sands and shales.
As oil demand
growth accelerates and supply growth continues to constrict in the coming
years, it is hard to imagine oil companies not regaining favor among
investors. These companies take big risks and generate huge profit streams,
along with high dividend yields that retiring investors (baby boomers) crave.
It is almost impossible to imagine a future where investors don't once again
start funneling huge amounts of capital into oil stocks and driving their
prices much higher.
At Zeal we've
been aggressively buying smaller high-potential oil stocks lately to game
this coming valuation-normalization trend. The current issue of our acclaimed
Zeal Intelligence newsletter discusses not only the oil spill's psychological
impact on oil stocks and the broader markets, but looks at one of the
most-exciting emerging oilfields in the United States today and the small
producers that are thriving in it. The oil stocks we've been buying and
recommending ought to easily double or triple the XOI's gains.
If you're
interested in commodities stocks in general, subscribe
today to our immensely valuable and practical monthly
or weekly
subscription newsletters. We continually analyze the stock markets and
commodities to uncover high-probability-for-success entry and exit points in
high-potential commodities stocks. New Zeal Intelligence subscribers will
receive a complimentary copy of our popular July issue focused on smaller
emerging oil stocks.
The bottom line
is oil stocks are deeply oversold and tremendously undervalued today. The
concurrent general-stock-market and oil corrections, along with the
horrendous oil-spill psychology, have left oil stocks one of the most unloved
and underappreciated sectors in the stock markets. Despite healthy oil prices
and endless future oil demand, investors have largely abandoned this sector
and left it for dead.
But like all
market anomalies driven by extreme sentiment, this one too will soon pass. As
the stock markets and oil recover, capital will increasingly flow back into
beaten-down oil stocks and drive up their prices. In addition to gradually
bringing their valuations back in line with historic norms relative to their
two primary drivers, this normalization will create great opportunities in
smaller high-potential oil stocks.
Adam Hamilton,
CPA
Zealllc.com
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