Is It Time to Buy Oil Stocks?

” The cure for high prices is high prices. The cure for low prices is low prices”

Is it Time to Buy Oil Stocks?

This question is a bit difficult to answer, but I’ll try to give you some ideas to think about. There are three things to think about before you take the plunge into buying oil stocks: public perception, company financials, and history. If you examine each of these for an oil company you are looking to invest in, then you might save yourself some aggravation.

Public Perception

“Is it time to buy oil stocks?” is one of the most common questions being circulated in the financial media. You will notice the level of public interest from these charts. Obviously due to the drop from above $100/barrel to below $30, the change in price has a lot of people talking… and searching for answers.

This is the public perception of “oil”, “oil stocks” and “oil prices”.

AS you can see, in 2009 and the start of 2015 the subject of oil prices was highly interesting to the public. Now compare this level of interest from the public with the price of oil and oil stocks measured by the ETF XOP.

Even though the price of oil futures has fallen over 70% and oil stocks fell around 68%, the public did not notice until December of 2015 when the prices had dropped 50% (most of the move). I think the opportunities for shorting these areas in a low-risk fashion have largely past. Despite the large drop in oil and oil stock prices, it may not be a great time to invest in oil stocks yet.

Typically the best time to buy is when the public interest largely wanes. This takes time. Since there is currently a high level of interest in oil and oil stocks, it is likely that the sector will continue to be less than favorable in the near future.

This is just the investor sentiment. If you account for the balance sheet and earnings of many oil companies, the horizon looks less favorable. Low oil prices and high leverage are not a recipe for solid growth…

Company Financials

Companies which are based primarily on a depleting resource, such as oil, gas, metals, or other commodities, do not have a perpetual business. Eventually, the commodity runs out or it becomes too expensive to mine. When these commodity companies encounter a rapidly falling price of that commodity, it is a recipe for disaster.

For example, take a look at the precious metals company prices. From the peak gold price in 2011 to the low in 2015, the price of gold dropped less than 50%. GDX (the ETF for precious metals mining stocks) from peak to the bottom early in 2016, dropped about 80%. This 80% drop didn’t happen right away. It took almost 5 years for that to happen.

The point is that despite the severe drop in oil prices, don’t expect oil stocks to rebound quickly.  Many of them have hedged the price of oil at much higher prices. However once those hedges run out, they will be producing at today’s prices. This will negatively impact earnings.

Hedging, in case you are not familiar with the term, is when a company agrees to sell a certain amount of oil at a certain price. in this example, a company decided to sell 2 years worth of oil production at $100 when oil prices are trading at $100. Then the oil price drops to $30. For the next 2 years, that oil company will be able to sell its oil at $100 when other people will be selling theirs at $30. This works well until the hedges run out and they are selling oil at $30.

If you think that it is a good idea to catch a falling knife, you might want to rethink that strategy. Many investors try to “catch a falling knife” while the price drops. This may seem like a good idea at the time, but picking a bottom in prices is a fool’s errand.

Patience is a virtue.

While it might be a bit early to start bargain hunting, it is not too early to start making your gift list. I would suggest finding the ideal companies you want to buy (not trade) and be patient for them to reach an acceptable level to invest.

History and Future

Given the potential risks looming in the global markets, oil and oil stocks should be approached with caution. Global growth is slowing and there is too much supply. Look at what happens historically when this is true. You will find that without a supply-demand equilibrium in balance at a price where it is economical to produce oil, low prices will persist until that equilibrium has been reached.

One crowd-based investor psychology to consider, Investors tend to be cautious with a drop in oil prices because they fear it is a precursor to a slowing global economy. In general, I would agree with this sentiment. We have seen low oil prices precede a slowing global economy over the past year. The global economic conditions outside the US are slowing quite noticeably, and the US economy is just starting to show signs of following suit.

Some people say that oil prices dropping is causing the economy to slow. It is quite the reverse. Lets take a look at a prior post: Where is the price of oil going?

If you want to know if now is the best time to buy, I would suggest that you make a list of the best stocks to buy and wait. If you read the last blog post you will understand some of the drivers of lower oil prices, and you will know when it is time to buy.

Why do lower oil prices matter to you?

While gas prices at the pump have been slow to catch up to the drop in oil prices, this will eventually help the consumer. They will have more money to spend in other areas and potentially could spend that money helping the US economy. However, this assumes that people will spend rather than save. This also assumes that the drop in oil prices does not reduce the number of jobs needed in the oil and gas service, production and exploration sector.

Here are some ways that the consumer will benefit:

• Lower gas prices at the pump– nothing more needs to be said about this…
• Lower costs to heat your home- Assuming you use oil or gas.
• Transportation companies: trains, planes and automobiles (a classic comedy), and trucking will benefit from lower oil prices, assuming they have not hedged their prices at a higher level. So your airline ticket prices should start to drop, and other travel related areas.
• Mining companies: whose costs are in large part due to energy prices, should benefit from lower costs.
• Chemical companies: whose product is comprised of petroleum (such as plastic) should also do well.

This post is a supplement to the Inflation Monitor January 2015 Issue.