Consumer Energy Report is now Energy Trends Insider -- Read More »

By Robert Rapier on Oct 2, 2007 with no responses

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.