Let Someone Else Squeeze Oil's Last

Everyone is familiar with the evolution chart, showing the path from a diminutive tree-swinging primate through various knuckle-dragging beefcakes and on up to the present-day pinnacle of homo economicus. Economies evolve as well.

The energy economy is still in the hunter-gatherer stage. We hunt deposits of petroleum, natural gas, coal and uranium, or to a much lesser extent, we gather sunshine, wind, hydroelectric and other non-fossil sources.

One consequence of hunting and gathering, as noted in last week's mention of Hubbert's Curve, is diminishing return on investment. This is the dilemma faced by the current oil and gas industry. The futures market expects prices to continue to rise, and prices must continue to rise if we are to stimulate both new production and increased efficiencies of demand. However, the inescapable consequence of diminishing returns is that the present high returns for oil companies simply are not sustainable, for reasons enumerated last week.

Weyerhauser can plant new trees after chopping down old ones, but Exxon Mobil(XOM) cannot replace nature's bounty once it has been extracted. Once hunted and once gathered, the resource dwindles.

Curves You Can't Ignore

As promised, it's time to update a column written in July 2000. Different indices, the S&P 500 ones that divide the energy industry into finer business descriptions than does the Amex's Oil Services Index or Oil Index, will be used.

A central argument within the July 2000 column was that investors were correct in interpreting the then-prevailing backwardation, or declining forward curves of both crude oil and natural gas futures, as skeptical of further price gains. As an aside, it's worth noting that futures markets, like the Supreme Court, are not final because they are infallible, but they are infallible because they are final.

While natural gas futures exhibit a declining forward curve through their normal seasonal cycle, crude oil now has a very different structure to its futures market. The forward curve rises into August 2005 and then begins to decline. This pattern reflects a belief that prices will not fall anytime soon.

Different Commodities, Different Curves

Source: Bloomberg, Howard Simons

More important, it is also a rational response by sellers of futures to the flood of long-only indexed commodity money. Too many investors now believe everyone can execute the same trade of selling the front-month future and buying the second-month simultaneously and with infinitely elastic liquidity. If, for example, May is trading for less than June, this trade will lose money. Such a development was predicted here last December in a section titled "The Warning."

Bull Market in Energy Stocks

Which of the various energy-related industry groups tracked by Standard & Poor's have fared best since mid-1996? The groups and their members, listed by ticker for the sake of brevity, are:

Top Performers These energy-related industry groups have fared best since mid-1996
Integrated	Drilling	Equipment	Exploration	Refining
AHC	NBR	BHI	APC	ASH
CVX	NE	BJS	APA	EP
COP	RDC	HAL	BR	KMI
XOM	RIG	NOV	DVN	SUN
MRO		SLB	EOG	VLO
OXY			KMG	WMB
			UCL
			XTO
Source: Standard & Poor's

If we take each group's performance relative to the S&P 500 and then divide this relative performance measure further by the cash price of West Texas Intermediate crude oil, an interesting pattern emerges. None of the groups outperformed the S&P 500 at a rate faster than crude oil prices climbed. Restated, the combination of an S&P 500 index fund plus long crude oil futures would have outperformed these indices.

Price-Adjusted Relative Performance of S&P 500 Energy Groups

Source: Bloomberg, Howard Simons

Now let's add one final twist, comparing the crude oil price-adjusted relative performance of the Integrated Oils to a simple measure of backwardation, the spread between the first two months of the crude oil futures contract divided by the price of the second-month future.

Backwardation Kills the Tiger in Your Tank

Source: Bloomberg, Howard Simons

The picture is clear: As backwardation decreases, which it is doing at the moment, we should expect the price-adjusted relative performance of the integrated oils to improve. If, however, the price falls and the forward curve of crude oil futures shifts into backwardation -- the back months collapse -- we should expect the entire oil sector to weaken relative to the broad market.

The hump in the forward curve suggests that we have at least a couple more months of high prices ahead of us, but remember how poorly the forward curve predicted the future. As has been noted here several times before, the futures market's job is not forecasting, but rather the definition of prices at which both buyer and seller can stay in business.

Backwardation is re-emerging in late 2005 and in later years. Given the proclivity of equities to move in advance of their underlying commodities, it might not be a bad idea to let someone else squeeze the last drop of oil out of Wall Street. The capacity of anyone to add value to an extracted resource is limited. Some may argue the topic of evolution, but none should argue the reality of diminishing returns.

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