Oil Price Cycle Not Heading Downward

Recently, we discussed oil prices and their affect on the oil & gas industry with Zacks senior analyst Sheraz Mian. He helped give us some well-needed perspective, as well as his top picks within the space.

Oil prices have been steadily coming down in recent days – from the all-time high of around $147 to under $110 at present. Are we seeing the bursting of the oil bubble?

I wouldn’’t call crude oil’s strength of the last few years as a bubble. While some ‘irrational exuberance’, to borrow a phrase from the former Fed Chief, could have been at work in oil’’s doubling in price over the past year prior to its recent pullback, there are nevertheless sound fundamental reasons for the commodity’’s historical strength.

The mismatch between the growth rates of supply and demand has been the driving force behind the current oil price cycle. The current pullback reflects the market’s realization that the outlook for near-term demand growth has weakened. Demand is weak in the mature OECD markets, but continues to be driven by growth in faster growing emerging markets such as China and India.

So is it fair to say that the oil cycle is ending – that oil prices will go down to historical levels?

We don’’t think that the current pullback is the beginning of the end of the oil price cycle. Far from it, we think that the pullback is useful for the cycle’s strength and stability. While prices can weaken some more, may be go under $100 over the coming weeks, but we think that most of the price drop is now behind us.

As I have mentioned many times in the past, there are fundamental reasons that support the current oil price cycle. Supply and demand of this non-renewable commodity is barely in balance, and there is very limited excess production capacity (kind of a supply cushion) in the global crude oil complex. It is the absence of a comfortable cushion in the shape of a large enough excess production capacity that magnifies the impact of real or perceived threats to supplies, such as problems in Iraq, instability in Nigeria, or Venezuela, or fears about Iran’s nuclear ambitions. Hurricanes in the Gulf of Mexico are another wild card having a significant price impact.

While it’s difficult to forecast near-term oil prices, we certainly do not expect prices to go to the historical low levels any time soon, if ever. We expect a period of price consolidation around current levels over the coming days, give or take $5-$10 in either direction.

With summer over now, attention will be shifting to winter heating and natural gas. How has that commodity been behaving lately and what is your outlook for natural gas prices. Are natural gas prices related to oil prices?

The natural gas market is fairly distinct from the oil market and generally has its own supply-demand dynamics. In theory, there is a relationship between the two commodities based on unit energy equivalency (the BTU content of 6,000 cubic feet of natural gas is equivalent to one barrel of oil), but it typically doesn’’t hold up in the market.

Natural gas trades in a local market (meaning North America) and local supply-demand forces determine its pricing direction. Natural gas demand has a very heavy seasonal component to it; the bulk of its usage is for heating purposes. It is also used for power generation, particularly in the summer peak usage months.

Typically, natural gas produced during the summer/fall months is stored and then taken out from the storage facilities during the winter months for consumption. The storage facilities get depleted during the winter heating months and re-filled during the summer months – that’’s the commodity’’s supply-demand cycle.

The last heating season was very favorable to the commodity; meaning that due to colder than normal temperatures, a lot of the gas in storage got consumed. This came after two back to back unfavorable winters when not much gas was used. As a result, the gas in storage at the end of the last heating season was lower than the year before.

While production and storage has largely been normal during the summer months, we are not out of the Atlantic hurricane season yet. On the whole, the storage picture now looks a lot better than it was earlier in the year, which is the primary reason why prices have been weak lately.

How would you advise investors looking to play the oil & gas space over the next quarter or two?

Almost all of the oil and gas sub-sectors have been under pressure in recent days due to the weakness in oil prices. On the whole, stock prices still reflect long-term oil prices that are significantly below current levels; so they have a lot of room to catch up. Some of these were cheap even before the current oil price weakness and are currently at very attractive levels.

So, for investors with a relatively low-risk threshold, the large-cap integrateds may be a relatively safe and stable group to be invested in. Remember, these companies both produce and consume crude oil. So, while their production units benefit from high oil prices, their refining and marketing units suffer.

My top picks have been Exxon (XOM), ConocoPhillips (COP), and Marathon (MRO) in this space. ConocoPhillips in particular is also a very North American natural gas producer, which gives you exposure to that commodity. Marathon has been an under-performer recently due to its large Midwestern refining/marketing presence, which has been battered by high oil prices. Marathon shares are very cheap at current levels.

Another major sub-sector is oilfield services and drilling. These companies do not need oil prices to be around $130-$140 to make a lot of money; they will be doing equally good in a $90-$100 oil environment. My top picks in this group include Halliburton (HAL), Baker Hughes (BHI), Diamond Offshore (DO), Transocean (RIG) and Pride (PDE), to name a few. While the first two are integrated service companies, the last three are offshore drillers, with rigs capable of operating in very deep waters.

Investors with relatively high risk appetites can look into companies more exposed to the domestic natural gas market. Here you would consider the exploration and production (E&P) and onshore drillers. We have long-standing favorites like Chesapeake (CHK), EOG (EOG), Patterson-UTI (PTEN), to name a few. Many of these companies have pulled back significantly in the last couple of months and are currently at very attractive levels.

Sheraz Mian is a senior analyst covering the oil & gas industry for Zacks Equity Research.

Posted in Categories: Contributor, Energy, External Research, Stocks.

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