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16-Mar-09
Bullish on Big Oil
Oil serves as an excellent economic barometer. Walk down the aisles of any store, and the effect of the economy on the price of oil is displayed. From an input cost in plastics to the cost of transporting goods to market, oil greases the wheels of commerce.
As we have entered the worst recession since the 1930s, it is unsurprising to see the cost of oil collapse. From a peak above $145 per barrel in July 2008, oil dropped to a low of $31.41 in five months (78%). During this price drop, the technical dynamics of the futures market became prevalent.
Futures contracts allow a person to buy or sell oil at a specific point in time at a set price. If you are an airline company looking to secure fuel for March, 2010, or an energy producer looking to lock in the price of a barrel of oil ten years down the road, the futures market helps. The price you commit to defines the nature of the market and indicates where prices are headed.
When oil was dropping to $31 per barrel, the market moved to contango. With a market in contango, the price of oil is higher the further you go into the future. For example, West Texas crude (WTI) on ICE trades for $47.17 in April, $47.83 in May, and $48.85 in June. Such a term structure allows profits for the investor who can buy oil today, take delivery, and then sell the same barrel in the future. Markets in contango are bearish and point to lower prices. Since the commodity in question will be driven into storage to take advantage of the large spread, excess supply is available to satisfy any increase in demand. Only when demand becomes so large that the contango narrows and then disappears has the excess supply been removed from the market.
As the contango has narrowed dramatically over the past few weeks (one month ago the difference between the April and May contracts was $4.46 versus $0.66 today), oil has moved higher. This is the first sign that oil has bottomed. I expect the price movement to continue and eventually result in a market where the futures months sell at a discount to the current month (backwardation). As contango is bearish, backwardation is bullish since all available supplies are rushed into the market to satisfy increasing demand.
Expecting oil to move higher, we must address the best method of becoming long. Although ETFs that track the price of crude are available, I will take a slightly different approach. When oil bottomed in mid December, ConocoPhillips (COP) and XTO Energy (XTO) were trading for $48.46 and $34.52, respectively. With oil now near $47 (52% higher), COP and XTO trade for $36.12 (25% lower) and $30.52 (12% lower), respectively. Simply put, two well-known energy producers now offer the ability to purchase their shares at large discounts to the price of the underlying commodity that drives their business. Instead of share prices increasing with the additional value of their balance sheet reserves, we have seen the opposite. Within this difference lies opportunity. Expecting the price of oil to continue increasing and the market to recognize the value of the reserves each company controls, in my weekly newsletter EPIC Insights, I recommend positions in XTO and COP as this week's fundamental trade.
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