Sector Rotation: A Drain in the Oil Fields

September 23, 2006

Money has flowed out of oil stocks over the past few weeks, bringing many down to yearly lows. Will current trends continue and doom the sector?

Most consumers have been pleasantly surprised to see falling gas prices over recent weeks at the pump. Some have also noticed their portfolios sink if they were heavily invested in oil. Oil prices have fallen sharply from over $78 a barrel to just $60.55 today. Fears of a slowing economy have hurt commodities, and the fear premium in oil has started to deflate.

The level of hurricane activity this year hasn’t reached the frenzied levels of last year, resulting in few disruptions to supply. Another catalyst is BP’s Prudhoe Bay oil field return to production. A leak in the pipeline caused fears that the 400,000 barrel-a-day field would have to be shut down. About 200,000 barrel’s-a-day of production was shut down following the leak, but 150,000 barrels will soon be brought back online.

The power to prop up falling oil prices lies in the hands of the Organization of Petroleum Exporting Countries (OPEC). The cartel can cut current production levels to reduce supply and keep prices up. About 40% of the world’s oil comes from OPEC.

Money has flowed out of oil stocks as other sectors including technology became more attractive, and profit taking seemed a good option for investors hoping to chase the hottest industries on Wall Street.

Large refiner Valero (VLO) has fallen 24% over the past month amid concerns about falling oil and gas prices. Valero was able to squeeze the most profit out of both high oil and gas prices because of its ability to refine cheaper crude oil into gasoline, resulting in a high “crack spread” of profit margins. Valero stock has been hit harder than most because it won’t be able to reap these benefits to the same scale it once did. Valero is currently trading at $48.19, very close to its 52 week low of $45.85, set last October.

The recent decline in Valero is likely overdone, and leaves the company undervalued. The current P/E ratio has come down to 6.20, and earnings will remain strong for the next few years as energy demand remains high. If any positive news on the oil front turns up, look for Valero to turn around and shoot upwards.

Oil behemoth ExxonMobil (XOM) has fared better than most, only falling 8% over the past month. Despite the relative strength it exudes, ExxonMobil will not have the same upside as smaller producers like Valero or Occidental Petroleum (OXY).

Occidental has fallen 15% during the past month, signaling its more mature position in the market. Its P/E ratio of 7.30 makes it a bargain, but Valero is the better investment following its further depressed valuation.

Look for oil prices to stabilize over the next few weeks, and oil stocks to recoup some of their losses. Although this won’t mean fresh highs, they should manage to outperform the broader market in the short-term following this correction. The drop in gasoline prices may actually help oil producers prolong their earning power by preventing an economic slowdown – consumers will now spend more of their income and keep the economy rolling along.

At the time of publication, Dhinesh Ganapathiappan did not own or control shares of any companies mentioned in this article.