Oil prices have experienced a significant surge of 15% in the past month, driven by Russia and Saudi Arabia's decision to cut production until the end of the year. This reduction in output has resulted in an oil deficit globally, forcing refiners to tap into storage reserves to meet customer demands. As a consequence, shortages have caused prices to skyrocket.
However, despite these promising prospects for the oil industry, oil stocks have remained stagnant. The SPDR S&P Oil & Gas Exploration & Production ETF (ticker: XOP) has seen a minimal decrease of less than 1% over the same period. This lackluster performance could be attributed to oil stocks already surpassing expectations earlier this year. It appears that now oil prices are finally catching up, leading to a modest response from investors. Additionally, concerns about the future of oil prices and the broader economy may be influencing this behavior. The futures market shows that Brent futures expiring in May next year are projected to drop to $88. Such expectations for lower prices could potentially weigh on shares in the sector.
Roth MKM analyst Leo Mariani highlights that investors may be skeptical about the sustainability of the recent rally in oil prices. Furthermore, they may perceive risks both to the economy and the oil market at this stage of the economic cycle. In times of potential economic slowdowns, energy stocks are often sold off as a precautionary measure.
In conclusion, while oil prices have experienced a notable increase, the same cannot be said for oil stocks. Investors seem reluctant to fully embrace this rally, expressing concerns over economic weakness and the future trajectory of oil prices. Only time will reveal if these reservations were warranted or if a shift in sentiment will propel the industry forward.
The Imbalance in the Oil Market: A Closer Look
As the demand for fossil fuels continues unabated and criticisms against oil and gas exploration mount, some investors perceive an intriguing disparity in the market. While major US oil companies maintain their high valuations, certain companies with slightly lower market values, like Occidental Petroleum (OXY) and ConocoPhillips (COP), find themselves trading well below previous levels. Bill Smead, Chief Investment Officer of Smead Capital Management, who holds oil company shares, highlights this intriguing trend.
For instance, when oil prices reached similar levels in November 2022, Occidental stock stood at a significant $73 while Conoco exchanged hands at $135. However, these same stocks are now valued at $65 and $123, respectively. This predicament has caught the attention of institutional investors who remain interested in oil stocks. According to Smead, these investors have gravitated towards major companies since the onset of the pandemic. When oil prices plummeted in 2020, only major oil stocks possessed sufficient market size to accommodate institutional investments without suffering from excessive market impacts.
"The much cheaper oil and gas shares are trading at much lower stock prices at comparable oil prices because they are still too tiny for the larger pools of money to consider," Smead remarks in a recent note.
Smead suggests that major oil companies may need to acquire smaller ones to capitalize on this disparity. Furthermore, he argues that investing in undervalued stocks presents an opportune strategy for investors.
Given the ongoing demand for fossil fuels and the absence of a viable alternative, it is evident something must give. As Smead convincingly notes, this could manifest in either a substantial increase in oil and gas drilling or more likely, industry consolidation by these large-cap companies. Interestingly, these same major companies were hesitant to pursue such consolidation when oil prices were significantly lower just a few years ago. In light of such circumstances, Smead believes that now is the time to seize an extraordinary opportunity by investing in undervalued oil and gas companies.
Indeed, as the market demonstrates an imbalance, shrewd investors can strategically position themselves to take advantage.
