The stocks in our "big oils" group have market capitalizations totaling more than $2.75 trillion. Any fund that didn't want to own more than 2% of this set of stocks wouldn't have trouble hiding $55 billion there.
A look at market indexes of major oil stocks, XOI and OIX, shows increases in value just this year of plus-21% to plus-23%.
That compares with gains in the same period of nearly 8% for the S&P 500 and plus-10% for Nasdaq. Given the herd instincts of professional investors, it is safe to speculate that virtually all of their portfolios that would allow it are crammed full of big oils. Which is one reason the prices are where they are.
Does this wide ownership of energy stocks on the part of institutional investors mean that these stocks are dangerous and should be avoided or shorted? Yes, maybe one or two should, but probably not most of them. At least that seems to be the sense of the pros helping these big funds acquire and dispose of stocks in volume.
Why should stocks that have run so far ahead of the market not be vulnerable to corrections? The simple answer is that they live in a profit environment that is much more favorable than most other stocks. It is driven by a worldwide energy shortage and free markets that are in the process of bringing the prices of various energy sources into line with each other and with the overall demand on a global basis.
There are two places where inordinate profits are to be made. One is in exploiting a scarce resource; the other is in pressing a desired product into the hot, sweaty palm of an ignorant consumer. Exxon Mobil (nyse: XOM - news - people ), along with others, represents the first example, while Microsoft (nasdaq: MSFT - news - people ) is an illustration of the second.
So where are we in the process of energy price realignment among alternative sources? For oil and gas, we are still early in the process. That is because the dollar cost per usable BTU at the point of consumption or conversion still favors those fuels at this time. Their extraction and delivery costs are relatively low for existing known reserves. Plus, the magnitude and rate of growth in energy demand worldwide is making those reserves relatively short- lived--on the order of a decade or less, unless major shifts in energy sourcing are undertaken for many applications.
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Inertia slows the conversions, forcing prices to recognize how precious those reserves are. The majority of big oils have demonstrated their inability to maintain reserve levels by internal exploration and discovery, simply because the volumes required are so large. That means they are headed toward merger and acquisition campaigns to shore up their needs.
The independent exploration and production (E&P) companies are the logical targets and beneficiaries of this consolidation trend. This is reflected in the difference in prospects for the group seen in its reward-to-risk trade-offs map.
Whereas the big oils map had no stocks with a plus-10% upside forecast, the E&P map shows at least half of the group at that level or above, and practically none with a plus-5% forecast or less. More than a dozen of these E&P names meet our policy hurdle for investment attractiveness. That compares with only one in the big oils group.
There is one timely illustration of the dangers that lie in the present picture of anticipating the values of exploitable reserves held by independent E&P companies. Interoil (nyse: IOC - news - people ) is a company that has identified potentially vast natural gas reserves on Papua New Guinea. Initially believed to be large enough to support the infrastructure required to liquefy and ship liquefied natural gas (LNG) from the island, a step-out exploratory well has not yet been successful in assuring the original notions. The well is not completed to depth, but the known results to date have been disturbing enough to crush the stock's price from over $40 to a low near $17.
Announcements that financing for the LNG plant and related facilities remain secure, and further details on the drilling results, have caused the stock to rise to $26, with upside expectations of $37, a further gain of plus-40%. From its present lower price level, roughly where it was in May, the stock now appears to be a reasonable speculative buy.
Other outstanding E&P buys are familiar names: Carrizo Oil & Gas (nasdaq: CRZO - news - people ), Range Resources (nyse: RRC - news - people ) and Southwestern Energy (nyse: SWN - news - people ). Then there are the dozen or so merely competitive E&P investments that meet our hurdle of prospects of at least a probable plus-5% gain in the next three months. They include Petroleum Development (nasdaq: PETD - news - people ), Swift Energy SFY - news - people ), Plains Exploration and Production (nyse: PXP - news - people ) and Tesoro (nyse: TSO - news - people ), among others. (nyse:
How can we be so comfortable about so many stocks that have been run up so far already in 2007? Don't those stocks embed in their prices the high current price of crude oil, their principal asset? What happens when it drops back to $30 from its present $70 or higher? Answer: Find someone willing to sell you crude for $30 and buy all you can. If you don't, there will be more than a dozen multibillion-dollar companies that will pounce on the offer.
The markets for crude oil bear this out, with quotes reaching out monthly for the next five to seven years at prices above $70. Yes, those prices can and do fluctuate some, particularly in the "front month" that reflects spot markets that are influenced by local and temporary conditions. But beyond that month or two, very little actual price gyration occurs.
And we know how to read the expectations for possible prices, both higher and lower, of the major players in the crude oil markets. We do it the same way we understand what volume stock market makers expect for prices of the stocks they are dealing in. Look at what they are willing to pay to protect themselves against such price moves. In crude oil now, that includes an expressed fear that prices might ease off as far down as $67 this year, $64 by the end of next year and $61 by the end of 2009.
Let's see now, you probably could make a living buying oil at $30 and selling it at $61. The other side of that trade is looking at higher prices. Their willingness to pay for protection when they have to be short crude goes as far as covering obligations as high as $79 to $80 per barrel this year, and $82 to $87 in all the first 10 months next year where we have sufficient data to read expectations.
Via: Forbes
by Peter Way (Block Trader' Oil & Gold Monitor)
