Making any assumption about the price of oil right now is risky, or some might even say crazy. Still, with WTI having found at least a temporary bottom around $50 and with an agreement to cut production by OPEC and the other signatories to the previous such deal looking on the cards, many will no doubt be considering oil stocks. They would almost certainly benefit from a recovery in price should a deal be announced, but there is also another reason energy stocks make sense at these levels. The drop in those stocks, and in oil itself, has been largely about pricing in risk, so it is reasonable to assume that said risk is now accounted for, which limits the downside. Of course, there is still risk to be considered though, and the normal way of reducing that risk, buying the large, integrated multinationals, may not be the best strategy this time.
The theory behind that strategy is sound. Companies like Exxon Mobil are not just involved in oil production. They also refine, distribute and retail oil and its derivatives which gives them some degree of cushion against price volatility. The point here though is that if you are thinking about buying the sector at all, you have to believe that crude is going to recover, or at least is not going much lower. That obviously negates one reason for buying the big firms’ stock, and the other, that international exposure also lessens risk, is even less convincing when you consider the evidence.
U.S. stocks have been volatile over the last couple of months and, while domestic concerns such as interest rates have played a part in that, it has also been about the fear of a decline in global growth. That contention is supported by looking at the dollar and U.S. Treasuries, both of which give an indication of the international market’s views of the relative strength of the U.S.
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As you can see, the dollar index remains elevated, but its rise has been quite steady, indicating confidence in the currency rather than panic-driven safety-seeking. Treasuries can also be places for big money to hide when it is running scared but moves in that marker are all about responding to expectations for the Fed, not global concerns.
It is said that money talks, and right now it seems to be saying that while trade issues and rising rates may hurt America, the U.S. economy still has the capacity to outperform. That suggests that domestic-focused oil companies may be the way to go, as do a couple of other important factors.
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Firstly, belief in a recovery in oil is based on belief that the OPEC+ group prop up oil prices. What we saw last time though, when the original deal was signed and implemented, was that while it drove up prices around the world, it also enabled U.S. E&P firms in the shale space to expand production to fill the gap. If the deal is extended, therefore, it could well usher in another period when those companies can defy the usual rules of supply and demand and increase output even as prices rise. Or, at the very least, stop them having to make cuts in response to lower prices.
Secondly, while conflict in the Middle East is nothing new, the brazen aggressiveness of the current Saudi regime and continued proxy wars between them and Iran make for even more instability than usual. That raises the specter of supply disruptions which would hurt multinationals with operations in the region but which could only help U.S. shale companies by adding to the chances of a price recovery.
All in all, then, if you look at the chart and conclude that it is possible that we have found a bottom for oil for now, the usually safe play of buying XOM, CVX, BP etc. is not the right one this time. Those stocks have greater exposure to international markets and stand to benefit less from a rise in oil. Domestic plays such as Diamondback (FANG), Devon (DVN) and EOG (EOG) have fallen further, so have more upside on a recovery and look better suited to the conditions that could spark one.
By Martin Tillier
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