Moving back to the short side on oil stocks

In my last post, I noted that the major opportunity to be short oil and gas company stocks had passed, and the comment was fortunately timed.  Yet I did not expect oil stocks to rally as much as they have - Rather, I had been expecting an opportunity to become long oil stocks to materialize.  However, since mid December, the XOI index of oil and gas equities has risen nearly 10%, while benchmark WTI crude prices have dropped by approximately the same amount.  Far from being a buying opportunity, this may be a chance to make more money on the short side.

Before waving away the recent rally in oil stocks, we need to be able to understand it's drivers.  Here I see three possibilities.

1.  Investors believe there is significant value in oil stocks at current oil prices.
2.  Investors are expecting oil prices to recover sharply.
3.  Investors are adding to risk positions in general.

I hypothesize about these possibilities below.

Do investors see value in oil and current oil prices?

The first potential explanation for the rally is that oil stocks had become undervalued given current oil prices, but this hypothesis can be quickly dismissed.  While oil prices have fallen by over 50% in the past 6 months, the XOI has only fallen about 25% in the same period.  Even clearer evidence that oil stocks are overvalued given current oil prices is seen in an RBC research note showing that large cap Canadian oil stocks are still discounting an $80 oil price, as shown in the figure below.

Implied WTI price in oil stocks (RBC Research)

Are investors expecting a rally in oil prices?

A second explanation is that investors are expecting a significant rally in oil prices and are discounting that ahead of time.  My experience is that oil stocks do indeed tend to lead oil prices, but a closer look at the data is necessary to make conclusions here.

First, looking at the NYMEX WTI Futures curve, we are starting to see a fairly steep contango developing in the oil markets.  That is to say, oil is more expensive to buy for future delivery than it is to buy in the spot market.  Steep futures curves greatly incentivize building inventories and buying oil in the spot market, because the oil can be sold for a higher price in the futures market at a virtually risk free profit.  Such arbitrages never last long, and it's likely that we will see a lot of inventory building demand supporting the oil price going forward.

WTI Futures Curve (Alhambra Partners)

Second, oil nearing bottom of my expected trading range of $40-60 based on production costs.  At current prices in the low $40s, only the most profitable core areas of shale plays can be economically produced.  Furthermore, cash flows at oil companies are becoming a major constraint to drilling.  It's therefore not surprising that we are seeing a rapid decline in the US rig count and that decline will continue until we see oil in the $50-60 range, which is a price that I believe will incentivize more drilling and stabilize the rig count.

The combination of a steep contango which incentivizes oil buying the the spot market, along with a drilling slowdown which will eventually constrain supply growth in the spot market, could support a short term rally.  However this is not a high confidence prediction - while the overall picture is supportive of an oil price rally, poor economic data or more bearish inventory/production data could continue to be a drag.

Are investors merely adding to risk positions?

A third explanation for the rally in oil equities is a general move into risk assets that has spilled over into oil equities.  While I don't have data to support this hypothesis, it does seem very likely. Surprise rate cuts and larger than expected stimulus measures in countries around the world have lifted equities across the board.  It should not be surprising that some of the money flowing into equities has found it's way into oil stocks.  However, risk based inflows can quickly reverse into outflows and this is not a sustainable driver for a rally.  At some point, oil will need to rally to justify the valuations of oil equities.

Oil may rally, but even so, oil equities are still overvalued.

For the reasons stated above, we should not be surprised to see a rally in oil prices in the coming weeks or perhaps even months ahead.  But would such a rally continue to support oil stocks?  Intuition would say yes, but data suggests otherwise.

Most alarmingly for investors in oil equities, the gap between oil and oil stocks has reached unprecedented levels.  The chart below shows the ratio of the WTI oil prices and the XOI oil stock index.  Until the recent sell-off in oil, this ratio was dropping gradually indicating moderately better returns for oil stocks than the commodity itself.  This gradual decline in the WTI:XOI ratio is expected behavior, as oil producers are able to find more oil and increase production (and profits) over time.  However, the sudden drop in the WTI:XOI ratio is not sustainable.  The XOI:WTI ratio is normally remarkably stable around it's trend line, and the concept of mean reversion almost certainly applies here.

Looking at the trendline on the WTI:XOI ratio, the bottom of the trend line would indicate a ratio of approximate 0.050.  This implies that even if oil rebounds to $60, assuming the XOI/WTIC returns to it's long term trend we would see a 10% decline in oil stocks.  This in itself is not a great result for oil stock investors, but the downside case is much, much worse. If oil prices continue to fall to $40, which is a very real possibility given deteriorating economic data, the XOI could drop 40% from current levels.

Based on this analysis, it appears that going short oil stocks is once again a very good bet on a risk/reward basis.

Short Positions

As a note of warning, never short companies with great assets or great management teams.  Companies with great assets often become acquisition targets, and companies with great management often find ways to persevere through tough times.   Instead, look for companies with the combination of marginal assets and poor management teams, because these companies are likely to go to zero.  It's not hard to think of names, Canadian Oil Sands and Linn Energy are two that come to mind immediately (and I am short both of these names).

Disclosure: The author is short Canadian Oil Sands (COS.TO) and Linn Energy (LINE)