Friday, 11 March 2005

Oil may be a bubble, but not oil stocks

Like Andy Xie, apparently Larry Kudlow thinks that oil is a bubble too.

Really, when I put $55 a barrel on the table and look at it from as many different angles as I can, there is no way to justify the current price. As a free market disciple, I am of course compelled to accept the market’s verdict. It is what it is. Fifty-five dollars a barrel.

But that doesn’t mean it’s going to last. Nor can we rule out a speculative bubble such as occurred with Internet stocks five or six years ago. Bubbles do happen.

Clearly today’s episode is demand-driven, quite unlike the supply shocks of twenty-five years ago... All this said, it is instructive to note how much higher oil prices have jumped in comparison to other commodity increases... It suggests that the oil sector is way out of line. Increased China demand cannot alone explain it. But over-speculation can...

In the meantime, small investors thinking about jumping on the gravy train of higher oil prices should beware. Bubbles do happen. And the oil market could be on the verge of a major bubble-bursting.

In a commentary for BusinessWeek, however, Peter Coy says that oil stocks may still be a good investment, but only for patient investors.

So is Big Oil still worth owning? For long-term investors, probably yes... Michael Mayer of Prudential Equity Group... figures investors are braced for oil prices to drop gradually to below $30 a barrel by 2007...

Stock prices also look moderate in relation to expected earnings of oil companies. Thomson First Call says that the price-earnings ratio of the sector, based on analysts' predictions of 2005 profits, is 14, vs. 16.4 for the overall Standard & Poor's 500-stock index. The only sector with a lower forward p-e is finance.

In contrast, momentum players looking for a quick kill had better watch out. With stockpiles of crude and gasoline rising, there's a good chance that oil prices will fall at least a little... That's because supply is exceeding increased demand... The Energy Dept. says that as of Feb. 25, U.S. crude inventories were up 9% from the year before, while gasoline supplies, despite a worrisome drop in refinery usage, were up 10%, above their five-year averages.

Coy's analysis suggests that while oil itself is liable to correct in the short term, oil stocks may still be worth a buy for the long term, a conclusion that is not out of line with those in an earlier post of mine.

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