The market's been wrong about oil before
Donald Coxe
National Post, August 19
With global stock markets once again strong after spring swoons, price-earnings ratios are back to lofty levels. Major indexes trade at multiples far above historic norms, reflecting the strongest global economy on record amid muted inflation.
When strategists and economists muse about threats to this near perfect climate for bonds and stocks, they routinely mention the threat of inflation from oil prices. To them, US$25 oil is a nuisance, US$30 oil an anathema, and the thought of even higher prices a nightmare. It is as if they were all drivers of gas-guzzling SUVs and considered it their god-given right to fill the maws of their voracious pets for US$20 or less.
That disdain for the oil industry extends to the valuation of oil shares. The oil industry globally has the greatest profit gains this year of any major group, yet its shares sell at modest valuations.
The market has had it wrong about the prices of oil and oil stocks for 18 months. The long mistake began with a sensational thinkpiece. In February, 1999, with oil prices below US$11, the prestigious Economist magazine ran a cover story predicting US$5 oil. That proved to be one of those cover stories investors associate with Business Week ("The death of equities" and "The death of bonds" just before historic bull markets in those assets were born).
Ironically, the article was so persuasive that it shocked the oil ministers of Mexico and Norway. They had always refused to join the Organization of Petroleum Exporting Countries, but the prospect of US$5 oil overcame their fear of being labelled demonic price-fixers. They cut a production-cutting deal with Saudi Arabia that made them visiting members of the club. Meanwhile, oil demand globally had begun to soar above industry forecasts as Asia recovered from its deflationary collapse. By September, Asian demand was 790,000 barrels per day above predictions, and OPEC's production was down 2.8 million bpd. Result, oil prices were at US$24.
Economists dismissed the run-up as a temporary aberration. Nor were they alone in their skepticism. Drilling for new oil continued to decline globally despite a doubled price. The oil industry had been so traumatized by the prospect of US$10 oil (let alone US$5) that it slashed its exploration budgets and refused to change them even as oil entered one of its greatest bull markets.
Natural gas prices were also leaping. That cutback in exploration hit gas exploration at a time when U.S. demand was climbing. In part, the demand was weather-related: 1999 was a hot summer, the kind that convinces otherwise rational people that global warming is for real. In part, the cause was shrinking supplies from the Gulf of Mexico: The production profiles of wells there has been disappointing; they start out running strong, but fade like out-of-shape joggers. The U.S. industry has not replaced its domestic gas production for five years, and that kind of attrition eventually produces a squeeze. Result: While oil was levitating from US$10 to US$25, gas was ballooning from US$1.80 to US$3.
Even a near record warm winter and a near record cool summer haven't driven natural gas prices down, and only the onset of large-scale deliveries from Canada has kept them from climbing above US$5 this year. Demand is rising from the electrical generation industry, as new entrepreneurs rush in to build gas-fired plants to replace output from ageing nuclear plants closing in response to rabid environmentalist coalitions.
As if mega-boosts in oil and gas prices weren't enough for the oil industry, even the sad-sack refining and marketing divisions of the U.S. integrated oil companies are showing rising margins.
How good is it when everything goes right? In the second quarter, per share earnings were up 128% at Exxon-Mobil Corp., 67% at Royal Dutch/Shell Group, 174% at USX Marathon, and 128% at Texaco Inc. Canada's Suncor Energy Inc., which is listed on the New York Stock Exchange, announced second-quarter earnings up a mere 255%.
Nothing on the horizon suggests a coming collapse in oil and gas prices. OPEC is pumping more oil, but wants to ensure prices don't break US$25. A normally cold winter should produce record prices for heating oil and gas. The oil stocks have performed well, but not in line with their profits.
The consensus is still wrong.
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