Oil Stocks Undervalued 2

The grinding 6-week-old bottoming process following the stock-market correction is doing its job, shaking out all the weak hands. These traders who haven't learned to suppress their own fear are selling low, disproportionately hammering popular sectors like commodities stocks. Excessive and unsustainable fear drives incredible bargains, including in oil stocks. They are super-oversold and very undervalued.

Of course oil stocks produce oil, the lifeblood of our global economy. Oil is the world's only meaningful transportation fuel, without it nothing moves. If goods can't be shipped, stores have nothing to sell and we all starve. As the foundation of this entire planet's complex logistics network, oil is worth any price. Adding to its value, once it is consumed it is gone forever. And large new deposits are ever harder to find.

So the producers of the world's most-important commodity enjoy a unique position. No matter how much oil they can discover and pump, eager buyers await. Unlike most businesses that never know whether their products will be in demand or not, oil is alwaysin demand. Every barrel produced can be easily and quickly sold. And with half the world still industrializing, global oil demand is only going to grow.

As a small businessman, I marvel at this. Imagine effectively-infinite demand for your product, no matter how much you manage to ramp up your production! Oil producers are in the catbird seat like few other companies can imagine. And no matter how scary the stock markets get, goods and people still have to move. As we saw during 2008's epiconce-in-a-century stock panic, oil demand is largely immune from even extreme stock fear.

Every company's stock price ultimately gravitates to levels that reflect its profitability, and oil producers' profits are directly driven by oil prices. So naturally higher oil prices lead to higher oil-stock prices. But stock-market fear causes traders to forget this critical fundamental link. They get so busy trying to rationalize their inherently-irrational fears that they forget oil prices are the key to oil-stock prices.

This is readily evident in the flagship oil-stock index, established 27 years ago but now unwieldly called the NYSE Arca Oil Index. Thankfully it is more commonly known by its ticker symbol, XOI. This index contains 13 major oil stocks with a mammoth collective market capitalization of $1450b as of the end of August. To put this into perspective, the 100 elite tech stocks of the NASDAQ 100 were only worth $2511b together. The XOI only has 13% as many components, but 58% of the market value!

Since oil prices directly drive oil-producer profits, the XOI/Oil Ratio is a great valuation proxy for this sector. As an American, I use benchmark US West Texas Intermediate crude oil in the denominator of this ratio. But this year we've seen problems with WTI, a local supply glut has led this metric to decouple from global oil prices. Earlier this week, WTI was still trading at a massive $25 discount to the global Brent oil price! Using WTI radically understates the case for rampant oil-stock undervaluation today.

This first chart looks at the XOR since 2008's stock panic, superimposed over the raw XOI itself. Though oil prices drive oil-stock profits, and profit levels ultimately determine stock prices, there has been a big disconnect between oil stocks and the crucial product they produce. Not only has oil-stock undervaluation been chronic since the panic, it is exceptionally so today following the recent sharp general-stock correction that has so frightened traders.

The first thing to realize is how anomalous this entire chart is. The last normal years for the stock markets prior to 2008's tremendously-disruptive stock panic were 2006 and 2007. Over this normality baseline, the XOI/Oil Ratio averaged 17.9x. In other words, the XOI oil-stock index generally traded at 17.9x the price of crude oil. Since they weren't so scared and jumpy back then, traders supported oil stocks at far-more-reasonable levels based on their core oil-driven profit fundamentals.

Back in December 2007, oil averaged just under $92 while the XOI averaged 1501 on close. Fast forward to July 2011, before the lion's share of the recent correction that terrified traders hit. Though the average oil price was 6.0% higher near $97, the XOI averaged 1314 which was 12.4% lower. And then in August when traders dumped oil stocks like oil was going obsolete, this divergence ballooned dramatically. The average oil price was just 6.0% lower than December 2007's, but the average XOI close was a whopping 24.2% lower!

This valuation of oil stocks relative to oil made no sense at all. Since the recent stock correction, oil has meandered between $80 and $90, averaging $86 in the 6 weeks since the flagship S&P 500 stock index (SPX) bottomed. Yet despite oil staying so strong even in the midst of stock fear slamming into its effective ceiling, oil stocks were disproportionately crushed. The XOI was trading around levels first seen back in mid-2006 when oil was in the mid-$60s! What on earth are traders thinking?

The chart above shows oil-stock undervaluations have been chronic since the stock panic. We have yet to get anywhere close to the normal baseline XOR levels seen in the pre-panic years. Capital invested in the major oil stocks comprising the XOI has unfortunately remained far below its pre-panic levels. Yet even within this stunted period, the XOR has seen highs and lows. The tide started to turn in mid-2010.

When the blue XOR line is rallying, oil stocks are outperforming oil. When it is falling, oil is outperforming the oil stocks. You probably remember the summer of 2010, when the media was freaking out about BP's infamous Deepwater Horizon oil spill in the Gulf of Mexico. While certainly a tragic event, traders lost sight of the inarguable fact that the world still needed vast quantities of oil despite occasional spills. The oil stocks, even those with no deepwater exposure, were dumped as if they were radioactive.

But just like today, this was irrational emotional selling. And that was very obvious at the time to serious students of the markets not deceived by the silly fear. In fact in July 2010 I wrote my other essay in this series, arguing that oil stocks were radically undervalued and a screaming buy. I caught a lot of flak from scared traders, but we bought oil stocks aggressively. Buying fear is the surest way to earn big profits in the stock markets. Just 7 months later, our subscribers realized profits averaging +90%!

While the XOR line above isn't quite as low today as it was in the summer of 2010, it's been pretty-darned close and right near this ratio's major support line. Trading at just 12.5x the price of oil is about as out of favor as oil stocks get as measured by this ratio, and this metric was just hit in recent weeks. Odds are oil stocks will soon catch a majorbid at these levels, and start regaining some lost ground relative to oil.

Ultimately oil stocks are certain to return to their pre-panic levels in the years ahead, as the stock-panic trauma and its aftershocks gradually fade from memory. But we don't need to solely bet on such a radical mean reversion. The last time oil stocks started gaining some favor was earlier this year when the XOR surged over 15. At the $86 average oil price in the 6 weeks since the SPX bottomed, a 15 XOR implies an XOI of 1294. This is 19% higher than where the XOI was trading this week before its latest plunge!

Now several factors make these potential gains incredibly conservative. First, oil prices are highly correlated with the US stock markets. Falling stock markets lead traders to assume the global economic outlook is worse than reality, so oil is sold aggressively. And as the stock markets recover out of their selloffs, oil prices rally in sympathy. Considering the extreme stock fear we've seen, oil has been remarkably strong. If it can still trade between $80 and $90 when the thundering herd thinks the world is ending, where will it surge to when traders calm down and get rational again?

Second, this XOR is based on an oil price that is increasingly viewed as a fiction by the world's oil traders. Despite the glut of oil in Cushing, Oklahoma where US benchmark oil prices are set, refiners all over the world (even in most of the US) are buying oil near the much-higher Brent benchmark price. Earlier this week Brent was running around $110 compared to $85 for WTI. Some American oil producers are even bypassing Cushing so they can sell at prices closer to Brent. If this XOR was based on global oil prices, oil stocks would look far-more undervalued than this distorted WTI read.

Third, the XOI is made up of giant oil companies with mammoth market capitalizations. They are like supertankers, so large and inertia-laden that their stock prices are slow to change. As a speculator, I much prefer to trade smaller fast-growing oil producers. While they fall farther when traders are scared, they really leverage the upside in oil prices and the general stock markets when fear inevitably passes and fades. As always, these high-potential smaller oil stocks will really multiply the majors' XOI gains.

While the focus of this essay is the unsustainable undervaluation of oil stocks relative to oil, the XOI technicals themselves are also worth considering. By the end of April when the general stock markets reached their latest interim high, the XOI had enjoyed a 59.5% upleg over 10 months. This was very similar to its last upleg ending in April 2010. And since that recent peak, this index has fallen 25.1% in just over 3 months in a sharp correction. This was very similar to its last correction in mid-2010.

So technically, despite all the crazy fear out there, the benchmark oil-stock index hasn't done anything out of the ordinary. Oil stocks rallied dramatically with general stocks, and then corrected hard with them. But they didn't enjoy a particularly-outsized upleg or correction, which increases the odds the bull market in oil stocks is alive and well. It's amazing a garden-variety correction has sparked so much fear.

This last chart looks at another oil-stock valuation proxy, the ratio of the XOI to the general stock markets as measured by the S&P 500. This XSR reveals when oil stocks are outperforming or underperforming the rest of the US stock markets. Like everything else in the markets, this sector's relative performance flows and ebbs. Periods of relative oil-stock strength are followed by weakness, and vice versa.

Though the XOI itself hit its latest interim high in late April the same day the SPX did, relative to the stock markets the oil stocks actually peaked a few weeks earlier. This oil-stock correction in relative terms is more mature than the general-stock correction. On top of that, oil stocks are back down to mid-2009 levels compared to general stocks. And amazingly they aren't too far above this ratio's 2008 stock-panic lows!

Given their unbelievably-low price-to-earnings ratios and deeply-oversold levels, oil stocks are likely to start rallying as soon as the general stock markets do. And after spending most of this year seriously underperforming the SPX, they are due to outperform again in their next upleg. While oil-stock prices relative to oil are far-more important than their levels relative to the SPX, this alternative perspective is still interesting.

There is no doubt that buying oil stocks when the stock markets are weak and everyone is scared is tough psychologically. Contrarian trading always is! But extreme fear leads to the best bargains ever seen in the stock markets. The optimum time to buy low is when everyone else is selling, so blinded by their own fear that they can't imagine anything but the current selling extrapolated out into infinity. But are oil stocks going to remain deeply out of favor and oversold for the coming 6 months? Almost certainly not.

Today oil stocks are abnormally cheap simply because everyone is scared. But how long can traders stay scared? Stock-market history is crystal-clear in showing thatextreme fear never persists for long, it quickly burns itself out. Contrarian traders strong enough to suppress their own dangerous emotions can load up on cheap oil stocks today, when no one wants them. Then all we have to do is allow some time to pass so rationality can inevitably return to the markets, and then sell high for big realized profits.

But which oil stocks to buy? My business partner Scott Wright and I were pondering this very question 4 months ago as we waited for a general-stock-market correction. So we started a big deep-research project investigating the entire universe of oil stocks trading in the US and Canada. We focused on mid-cap oil stocks with market capitalizations ranging from $2b to $10b. This is the sweet spot of highly-leveraged companies with growing oil production that really amplify moves in oil and the far-larger XOI stocks.

We just finished many hundreds of hours of research narrowing down these oil stocks to our dozen favorites fundamentally. They run the gamut from companies focusing on North Dakota's hot new Bakken oilfield, to incredible oil-sands projects in Canada, to an offshore producer. Scott wrote a fascinating and enlightening 36-page report that profiles each of these elite mid-cap oil stocks in depth. Hot off the presses this week, it is available for just $95 ($75 for Zeal subscribers). Buy yours today!

We also publish acclaimed weekly and monthly subscription newsletters. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, and how to trade them with specific stock trades when opportunities arise. Our track record has been stellar, since 2001 all 591 stock tradesrecommended in our newsletters have averaged annualized realized gains of +51%! We achieved this by buying low when others were scared, and selling high when others were greedy. If you want to learn how to thrive in the markets like a contrarian, subscribe today.

The bottom line is oil stocks are very undervalued relative to the oil prices that drive their profits. While oil has remained high and resilient despite all the stock fear, traders are scared. They are foolishly ignoring strong oil prices to dump its producers with reckless abandon. This has driven oil stocks down to silly levels that can't and won't last once this fear inevitably passes over. Contrarians can capitalize on this.

Oil remains the lifeblood of the world economy, and demand is going to grow relentlessly in the coming years as Asia continues to industrialize. The companies that produce this unique and scarce commodity will easily sell every barrel they can pump, likely at high and rising prices for many years to come. Big profits will attract big capital, driving big gains in oil stocks as they rally to reflect prevailing oil prices.

Adam Hamilton, CPA

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