Market shocked to find that energy demand can be reduced
The rebound in the price of crude oil to about US$60 a barrel puts it right in the middle between its recent low and recent high. Many investors are similarly stuck in the middle: Are they witnessing a sucker's rally or a genuine surge that they should join?
Oil is certainly in the midst of an interesting ride. Crude hit US$77 a barrel last summer, amid theories of dwindling supply growth and surging demand, as the global economy continued to barrel along.
It then began a steady decline, taking energy stocks down with it, as the demand part of the theory started to crumble. Oil hit a near-term low of about US$50 a barrel in mid-January. Turns out, conservation efforts, along with "demand destruction" that occurs when consumers park their SUVs and pick up skateboards, meant that demand for crude actually fell in developed economies last year, for the first time in decades.
Sure, developing economies like India and China were devouring ever-larger quantities of energy to run their economies. But the fact that it was actually possible for energy consumption to reverse scared away a number of investors. It didn't help that the Organization of Petroleum Exporting Countries announced production cuts to head off the price decline. If OPEC members, which constitute the world's oil cartel, thought there wasn't enough natural demand to bolster the price of oil, why would Joe Six pack bet against them?
Oil has since rebounded because -- wonder of wonders --cold winter weather has enveloped much of North America over the past several weeks, creating greater heating needs and the possibility of dwindling energy supplies. The Canadian dollar, which tends to track commodity prices, has also recovered some lost ground. It bounced three-quarters of a cent against the U.S. dollar yesterday, taking it back above the US85? level.
Today, with the price of oil somewhere in that vast middle ground between cheap and expensive, some investors are buying energy stocks on the understanding that they're cheap.
George Vasic, strategist at UBS, pointed out in a research note yesterday that energy stocks tend to perform well between February and April, with average gains of 8.3% since 1988 (versus just 1.6% for the S&P/TSX composite index). As well, UBSanalysts estimate that the earnings of energy companies should grow by 15% in 2007 with oil at US$60 a barrel.
"Accordingly, this is the time to give energy shares a chance," Mr. Vasic said.
He added Suncor Energy Inc. to his 12-stock portfolio (replacing Nexen Inc.) on the belief that the stock has a 39% upside potential based partly on its price to net asset value. The Vasic portfolio, which has a 33% weighting in energy stocks, also holds Canadian Natural Resources Ltd. and Petro- Canada.
Should you follow Mr. Vasic's lead? You'd have to be brave, given that yesterday's winners have a bad habit of remaining in the dumps for some time after they've fallen out of favour.
Chen Zhao, managing editor at BCA Research, noted that things still look shaky for oil in the nearer term. Too many investors remain bullish, he said, which leaves plenty of room for a further drop. As well, oil demand in China can fluctuate wildly as authorities there try to engineer a slower-growing economy. And finally, if the U.S. dollar recovers from its current woes -- as he expects -- commodity prices could turn soft, since they are priced in greenbacks.
"From a long-run viewpoint, the recent correction, though sharp, may not have been deep enough to allow for an uptrend in prices to be re-established," Mr. Zhao said.
"We should note that the crude market would still be in a bull market even if prices were to drop to US$45 a barrel." That's 25% below current prices -- and it represents a substantial risk.
Oil is certainly in the midst of an interesting ride. Crude hit US$77 a barrel last summer, amid theories of dwindling supply growth and surging demand, as the global economy continued to barrel along.
It then began a steady decline, taking energy stocks down with it, as the demand part of the theory started to crumble. Oil hit a near-term low of about US$50 a barrel in mid-January. Turns out, conservation efforts, along with "demand destruction" that occurs when consumers park their SUVs and pick up skateboards, meant that demand for crude actually fell in developed economies last year, for the first time in decades.
Sure, developing economies like India and China were devouring ever-larger quantities of energy to run their economies. But the fact that it was actually possible for energy consumption to reverse scared away a number of investors. It didn't help that the Organization of Petroleum Exporting Countries announced production cuts to head off the price decline. If OPEC members, which constitute the world's oil cartel, thought there wasn't enough natural demand to bolster the price of oil, why would Joe Six pack bet against them?
Oil has since rebounded because -- wonder of wonders --cold winter weather has enveloped much of North America over the past several weeks, creating greater heating needs and the possibility of dwindling energy supplies. The Canadian dollar, which tends to track commodity prices, has also recovered some lost ground. It bounced three-quarters of a cent against the U.S. dollar yesterday, taking it back above the US85? level.
Today, with the price of oil somewhere in that vast middle ground between cheap and expensive, some investors are buying energy stocks on the understanding that they're cheap.
George Vasic, strategist at UBS, pointed out in a research note yesterday that energy stocks tend to perform well between February and April, with average gains of 8.3% since 1988 (versus just 1.6% for the S&P/TSX composite index). As well, UBSanalysts estimate that the earnings of energy companies should grow by 15% in 2007 with oil at US$60 a barrel.
"Accordingly, this is the time to give energy shares a chance," Mr. Vasic said.
He added Suncor Energy Inc. to his 12-stock portfolio (replacing Nexen Inc.) on the belief that the stock has a 39% upside potential based partly on its price to net asset value. The Vasic portfolio, which has a 33% weighting in energy stocks, also holds Canadian Natural Resources Ltd. and Petro- Canada.
Should you follow Mr. Vasic's lead? You'd have to be brave, given that yesterday's winners have a bad habit of remaining in the dumps for some time after they've fallen out of favour.
Chen Zhao, managing editor at BCA Research, noted that things still look shaky for oil in the nearer term. Too many investors remain bullish, he said, which leaves plenty of room for a further drop. As well, oil demand in China can fluctuate wildly as authorities there try to engineer a slower-growing economy. And finally, if the U.S. dollar recovers from its current woes -- as he expects -- commodity prices could turn soft, since they are priced in greenbacks.
"From a long-run viewpoint, the recent correction, though sharp, may not have been deep enough to allow for an uptrend in prices to be re-established," Mr. Zhao said.
"We should note that the crude market would still be in a bull market even if prices were to drop to US$45 a barrel." That's 25% below current prices -- and it represents a substantial risk.
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