The disconnect between soaring commodity prices and
languishing oil company stock prices has been an exercise in frustration
for many industry folks.
After all, most of the pundits agree the combo of tight global
oil supply, soaring demand and terrorist threats to infrastructure
and more make it unlikely commodity prices will crater — at least
Yet the companies in general have been very reluctant to ramp
up drilling activity to the point one might expect.
In a sense, they're damned if they do and damned if they don't.
Wall Street wants growth but hates risk. Yet risk is indigenous
to the business of drilling — dry holes are all in a day's work,
so to speak, especially now that most of the easy finds have been
tapped. But let a public company hit a couple of dusters, and the
downward spiral of its stock price can cause a dizzy spell for even
the most stalwart observer.
The Wall Street crowd also demands quarterly results — but oil
and gas is not a quarterly business. This essentially discourages
drilling all but the increasingly rare slam-dunk-type prospects
at a time when the need to explore for new production and reserves
is more pressing than ever.
There have been reported rumblings within the financial community
about the need to reward oil companies for growth rather than return
on capital. Any pronouncements, however, are yet to be heard.
Even so, Richard Bernstein, chief U.S. strategist at Merrill Lynch,
noted in a U.S. Strategy Update in July that "energy is the best
long-term growth story in the U.S. economy."
He qualified the remark, however, with the caveat that "energy
is a very cyclical sector."
Recent activity on Wall Street suggests a hint of attitude-shifting
relative to investing in the oil and gas sector. Indeed, publicly
available data indicate a number of investors began moving into
these stocks fairly recently.
Somewhat ironically, this movement coincided with the late-August
decline in oil prices once they began to nudge the $50 per barrel
There apparently was "method to the madness."
For instance, a number of industry analysts upgraded myriad companies
across the board, i.e., E&P, drilling, service, noting they
anticipate continued strong commodity prices, albeit not necessarily
excessive — i.e., $50 or more.
Investors who jumped onto the buying bandwagon, more or less at
this same time, included some of the hedge funds — investment vehicles
for institutions and the uber-rich, which have become a speculator's
paradise of sorts. In fact, near-legendary oilman and AAPG member
T. Boone Pickens is at the helm of a $500 million hedge fund.
When soaring commodity prices suddenly reversed course, the relatively
low-priced oil and gas companies apparently began to look like wise
bargains compared to futures contracts and options.
The Volatile Cycle
Still, it's a gamble — a daunting world even for the professionals,
and especially the individual investor.
Perhaps the most striking example of the extreme risk/reward cycle
is the oil field service sector.
"What moves stocks is expectations of the future, of what that
business will be at some point in the future," said Jim Wicklund,
managing director at Bank of America Securities, who was recognized
in 2002 as a top stock picker in the Wall Street Journal's "Best
on the Street" survey.
"What moves the oil service stocks is expectation of higher spending
by the E&P industry — not that high levels of spending will
be maintained, but that spending will go higher," he said.
"Not only does the expectation of higher levels of business move
these stocks," Wicklund added, "the expectation of high volatility
periods of rapid ramp-up of activity moves them."
When asked why the stocks move up and down seemingly as one rather
than as the individual entities they are, the veteran energy analyst
has a simple explanation.
"When the stocks go down, they all go down, but some more than
others," Wicklund said. "Companies by virtue of geographic location,
geographic weighting of revenues and income, by their technology
(and) inherent leverage will perform differently.
"We did a study that showed when U.S. drilling has an up-cycle,
the contract land drillers and the mid-cap service companies will
out-perform," he said. "When the U.S. cycle is down — like now
— the best performing are the Schlumbergers, Halliburtons and the
like, because they only have a 25 to 35 percent exposure to the
U.S. market. Then when the U.S. cycle goes up, they under-perform
For investors seeking roller-coaster thrills, this is the way
The oil field service sector is the most volatile industry sector
behind semi-conductors, according to Wicklund, and the individual
investor can't keep up.
"Every hedge fund in America plays oil field service stocks, which
increases their volatility," he said. "Also, this is a cyclical
industry, as opposed to a growth business where it's safer to own
for 10 years.
"With oil services, you can make a huge amount of money in two
years and lose it back in six months," Wicklund noted. "This is
what keeps a lot of long term investors away from the group, which
further exacerbates the volatility.
"If long term owners don't want to buy and hedge funds like the
volatility and are the only ones who own," he continued, "then the
stocks whipsaw back and forth at blazing speeds.
"It's a self-fulfilling prophecy."
How High is High?
Now that the oil industry once again has emerged from near-obscurity
in the back pages to front-page status, a lot of in-the-know folks
question the perception of many members of the financial community
that "it's really different this time."
"All of us who have been in the oil business 25 years and more,
which includes the people running the companies, have seen investors
on Wall Street going ga-ga that oil's going to $100 several times
before," Wicklund said. "And each time, three years later oil is
down 50 percent.
"But a lot of them believe it's really different this time," he
said, "and that it's really going to happen. That's when you run
for the trees."
On an up note, Wicklund does see prices sticking above $30 for
a long time. He just won't place any bets that at $50, it's going
to see $60 before it sees $40.
"Economics is a self-correcting ebb and flow of business," Wicklund
noted. "How do you cure a shortage? You raise prices.
"People say demand in China is going up no matter what," he said,
"but on a relative basis no country or industry is immune to the
impact of economics. Thirty-five dollar oil may not slow China,
but $60 might.
"It takes a record price to have some impact," Wicklund said,
"and I won't guess how high prices may go. But I'll tell you what
the impact will be — they'll go high enough to balance supply and
demand. Whatever that price, we'll hit it."