Wall Street Has Its Own Rules

And, Oil Stocks Have Their Own Personality

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 anytime soon.

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."

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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 anytime soon.

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 mark.

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 the index."

For investors seeking roller-coaster thrills, this is the way to go.

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."

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