Why the market is wrong about oil

The disconnect in this commodity market may confound reason, but a few oil stocks make great sense. Here's what to look for, and how you can profit.

By StreetAuthority Aug 12, 2013 5:01PM
Image: Oil Well Pumpjack © Roger Milley/Vetta/Getty ImagesBy Adam Fischbaum

The duck-billed platypus defies all scientific reason.

This beaver-tailed, otter-footed, semi-aquatic creature is the only mammal on the planet that lays eggs instead of giving live birth. On top of that, it is the ONLY living representative of its family and species. Basically, the platypus is an inexplicable freak of nature. Although the platypus officially has no relatives, I have a theory that it may be distantly related to financial and commodity markets -- which often also look really weird and defy explanation.

Recently, I've noticed an odd disconnect between the price of oil and the performance of oil- and energy-related stocks. I'm no Dennis Gartman or Jim Rogers, so reading commodity price tea leaves is not my thing. But there's something going on -- and if there's something quirky going on in the investment world, there's an opportunity to make money.

Here's an interesting chart of the one-year price action on West Texas Intermediate crude (WTI):


The spot price of this Texas tea is up 13% over a one-year period. Why? Good question. Typically, oil prices (and the prices of other commodities) rise when the U.S. dollar is weak. However, that's not the case.


Although the greenback appeared a little weak at the end of last year, the dollar has spent nearly a year where the value currently sits with enough volatility in between to make some extremely coordinated traders some money. But for folks like us, there's not much change.

As a whole, commodity prices are in a steady downtrend (I briefly examined the end of the commodity super-cycle earlier this summer) -- except for oil. What gives? Like the duck-billed platypus, it defies explanation.

The new oil boom
Analysts and investment writers continue to chatter about the new U.S. oil boom. Thanks to fracking technology and recent discoveries, American energy security appears within grasp. The U.S. has become one of the world's largest exporters (yes, exporters) of refined petroleum products.

However, a glut of global supply is inevitable. Economics 101 tells us that higher supply eventually results in lower prices, and the global oil supply is heading that way very quickly. Conventional logic would tell us prices should be lower or trending lower. They don't seem to be.

Anecdotally, investors usually lift the prices of oil-related stocks as oil prices climb. This is happening, but only selectively. Some of these names are commanding unjustified premiums. However, there are a handful of oil-related stocks that have been mispriced or overlooked -- and offer extremely attractive value and profit potential (and some that aren't as promising).

Oil patch bargain bin
Valero (VLO): The world's largest independent petroleum refiner and marketer trades at a nearly 50% discount to the price-to-earnings (P/E) ratio of the S&P 500 index. This $19 billion market cap player is benefiting from increasing domestic oil production, lower input cost and growth in U.S. refined product exporting. Shares trade at around $37 with a forward P/E of 9 and a dividend yield of 2.5%.

Petroleo Brasilerio (PBR): Petrobras is Brazil's (the B in "BRICs") national oil company. Although emerging markets have cooled recently, Brazil still remains an attractive opportunity --  thanks to its young and growing middle class. The downside is a weak currency and small pockets of social unrest. That aside, Petrobras has leveraged its large domestic reserves and exploration success to position the company as the dominant energy producer in Latin America. The stock looks cheap at around $14, a 43% discount from its 52-week high, with a forward P/E of 7.3 and a 2.6% dividend yield.

Phillips 66 (PSX): Spun off from oil giant ConocoPhillips (COP) last year, Phillips 66 was the refining and marketing arm of its former parent. Again, with the upswing in U.S. oil output, refining is the place to be. The company also holds significant assets in the natural gas liquids (NGL) space which, despite low natural gas prices, will be a growth going forward. With a market cap of $36 billion, this big company looks downright cheap at around $59 a share with a forward P/E of 8.3 and a 2.1% dividend yield.

The dry holes
Halliburton
(HAL): While a legend in the oilfield services business and an insanely well-run company, it's hard to get excited about shares of Halliburton. The stock price sits near its 52-week high at nearly $46. The forward P/E isn't all that unreasonable at 14, but the dividend yield of just above 1% is miserly for a $42 billion company that generates over $4 billion in annual free cash flow. This is a valuation call. The price and the compensation just don't justify ownership. In addition to the toppy price, too much legal risk remains from the Deepwater Horizon disaster fallout.

Schlumberger (SLB): Another legendary name in the oil services business, Schlumberger, like its archrival Halliburton, looks a little expensive. Shares trade at around $80 with a forward P/E of 18 (pretty much equal to that of the S&P 500). The company is also stingy with its annual free cash flow of nearly $9 billion, paying out a measly 1.5% dividend yield. As with Halliburton, there's not enough incentive to own the shares. Schlumberger's over-reliance on drilling in the Gulf of Mexico can also be seen as a liability -- as activity in that region is growing at a slower pace due to increased activity in land-based exploration in North America.

Nabors Industries (NBR): As the world's largest land oil drilling contractor, it would seem that Nabors would be a no-brainer route to participating in the North American oil renaissance.  But looking under the hood of this one tells me otherwise. Earnings growth is less than impressive. 2012 earnings per share (EPS) came in at 82 cents. Estimates for 2013 are for 85 cents a share. 3% EPS growth from the biggest player in a booming sector isn't enough to get impressed by. Return on equity is also unexciting at just 4.2%.The 1% dividend yield isn't that attractive either.

Risks to consider:
Oil prices have gone up, which means they are destined to fall sooner than later. Crowd psychology typically takes over, which means that the prices of oil related stocks should go down, too. The lower valuation metrics and decent yields on the stocks I like should help combat that movement. Also, keep in mind that we are about to enter the busy portion of the Atlantic hurricane season, this always has a negative impact on refiners due to their presence on the Gulf Coast.

Action to take:
Collectively, the bargain basket of VLO, PBR, and PSX trade with an average forward P/E of 8.2 and a dividend yield of 2.23%. Modest P/E expansion of 25% -- going from a P/E of 7 to a still cheap P/E of 8.8 -- would result in one-year returns of 25% or better for the basket. Factoring in the dividend, potential total return would be north of 27%.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.
 
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12Comments
Aug 12, 2013 9:08PM
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Another idiot paid by Big Oil to pump it's stock price. By the way... "forward" means a wild guess in a cup of Kool Aid. It's your money, fools...
Aug 13, 2013 8:13AM
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Face it. There is no such thing as a free market anymore. Go ahead. Try to name a commodity or industry that is not in some way subsidized or price supported to offset market conditions or competition.

Our oil industry is one of the most subsidized. And what do we get? Higher and higher prices at the pump while the oil companies and execs get record profits and insane compensation packages. Yet we continue to give them our taxpayer dollars in subsidies and pay high taxes and prices on gas at the pump.

Aug 13, 2013 5:52AM
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The market is never wrong...Whatever article starts with "the market is wrong about..." shows that the guy has lost much money before. The market is never wrong. It just is.
Aug 12, 2013 11:11PM
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Sold a REIT this morning....Late p.m. maybe.

 

Rounded out some COP on a dip (still pricey) wanted even 100 share lots, easier to figure.

 

And filled for 200  NTI on a limit, for starters; May not get more, we'll see.

The fill/buy orders went pretty early.

 

My luck 2 out of last 3 times cas has not been good, taking a breather.... 

Aug 13, 2013 6:27AM
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"Risks to consider: Oil prices have gone up, which means they are destined to fall sooner than later."

 

The 800 pound gorilla in that Risk Room is the fact that hyper-inflation is about to absorb everyone's remaining income. It's a tug-o-war between Big Financial Pariah and Big Oil Cartel. For the 90 million under and unemployed, the automobile is about to become a HUGE liability... coming in the form of a major auto coverage insurance hike. It doesn't matter what gas costs if driving the car itself takes the dinner off the table. Even Republicans are reconsidering the Party of NO and stonewalling the tax on wealth, wealth-mongering, morons in markets and institutions that are not doing good for America. I see the need for a Flat Tax and Exception Tax racing toward passage before year-end. There is the proposed Major Bank Divestiture legislation sponsored by McCain and Warren heading toward vote very soon. With prospects of a total eclipse for GOP candidates now a reality, getting a series of greed-squeezing measures in place is their only hope. To remain IN stocks is stupid, the Laws of Nature don't favor them and all roads are leading to-- closing the banks, ending the Fed and getting rid of Wall Street. If it's all you know, where does it leave you?

Aug 13, 2013 7:22AM
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Forcing folks to have Auto insurance isn't much different than forcing folks to have health insurance. Yet there are Zero people in Congress voting 40 plus times to due away with mandatory Auto Insurance. There are literally Zero folks posting about doing away with mandatory Auto insurance. Now I am not stating which side is best nor which side that you should take, only that I really don't see that much of a difference.

Now concerning the Markets and Oil, everything is Wrong in a Market that's totally manipulated by the Oil Cartels, regardless of country of Origin. It we can Frack, so can they. If we really had Free Markets, gasoline would be around 2 Bucks. Instead, we pay hundreds of Billion each year in the form of a Tax to Big Oil. And you don't see folks voting 40 plus times to complain about that either.

Aug 12, 2013 8:55PM
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Forward P/Es are always a crapshoot, without embedded history or damn good reasoning.

Yes, I agree wholeheartly with your synopsis.

But then I would also agree, the ensuing article, is also a chartist' dream. 

Aug 12, 2013 8:18PM
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"Forward earnings" are thrown around as if their a sure thing and indicate the so-called "cheap" P/E's based on trailing earnings are above 10 - especially Halliburton with a "forward P/E" of 14.

Consider these current P/E's based on trailing earnings and annual dividends:

Exxon (P/E = 11, Div = 2.7%)
BP (5, 5.2%)
Chevron (9.9, 3/3%)
Conoco Phillips (11, 4.1%)

It's unfair and a downright misleading to write something like "...trades at a nearly 50% discount to the price-to-earnings (P/E) ratio of the S&P 500 index..."

When the four stocks I listed also average about half the 19.2 avg. P/E for the S&P 500.  The sector trades at low P/E's and it's deceitful to imply they should rise.


Aug 12, 2013 10:40PM
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Picked up another 100 shares of GOODO Monday a.m.at $25.10 a share.

 

Good weekend at the casino.  Casino gave me $20 free slot play and $10 match play at table games.  Cashed out the $20 free slot play and put it in my wallet.  Bet $10 at blackjack with the free $10 match play.  Dealer gave me two 10s and I stood.  Dealer stood with 19.  I watched three hands play out  first before sitting down (which the casino frowns upon) and saw lots of small cards coming out.

 

Put $5 into video poker betting $1.25 a hand for a $1250 royal flush payout.  Went up and down, then got dealt two 2's.  Held the low pair and drew two more 2's with an Ace kicker.  Won $200, 800 quarters.  Ya gotta love it.  And this is an Indian casino.  These are not slot machines.  They are video lottery terminals.  They work like pull tabs.

 

The wife lost on the new Michael Jackson slot machines, but she likes the music and graphics.

 

How is the buy order on NTI going?

 

 

 

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