Bull Case on Oil Stocks Hasn't Waned

Some think the sector's recent pullback means crude is set to crash. Others see a buy signal.
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Having been completely wrong about the direction of oil prices this year, many Wall Street analysts were quick to seize upon the recent underperformance of oil stocks as a sign that things are peaking out.

A handful of money managers disagree.

Despite rising in tandem with oil prices this week, the Amex Oil Index is down more than 7% since hitting a high on July 16. Meanwhile, the price of crude has jumped 16.5% on concerns that capacity might be too limited to take care of any supply disruptions or potential spikes in demand.

One reason oil stocks and oil prices have diverged of late is that investors have been booking profits after a strong run. Since the start of the year through July 16, the Amex Oil Index gained 20% while the broader market fell almost 1%.

Talk that oil prices are cresting and speculation that the government could open the Strategic Petroleum Reserve have also contributed to the decline in energy stocks, say some fund managers.

Still, these experts say the rally in the oil sector is far from over, and that opportunities remain for long-term investors.

Stephen Leeb, president of Leeb Capital Management, thinks oil prices are in a long-term uptrend, and he has called for crude to rise to $100 a barrel over the next three or four years.

"If your perspective is 18 to 24 months, I think

the energy sector is dramatically undervalued," he said.

Even though oil stocks have advanced this year and profit forecasts are increasing, many companies, such as


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Devon Energy

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, continue to trade at single-digit multiples, reflecting Wall Street's belief that high oil prices are temporary, Leeb said.

Yet the consensus on Wall Street has been wrong for at least five years. "At the end of 1998, oil was at $12 a barrel, now it's over $45. That's a very strong uptrend," he said. "During this time, not one major Wall Street firm has been willing to forecast higher oil prices 12 months forward."

Joe Dancy, manager of LSGI Advisors and an adjunct professor at Southern Methodist University, noted that most analysts are calling for oil to fall to $30 a barrel this year, which he said is "a long shot at best."

"Trends in the energy sector remain attractive for investors," he wrote in a recent report. "Worldwide demand for crude oil remains strong."

Rising consumption around the world has prompted the International Energy Agency and the Organization for Petroleum Exporting Countries to boost their forecasts for oil demand this year and next. Although supply has also been increasing, investors worry that OPEC has little excess production capacity to cushion against any supply disruptions.

Since psychological concerns have also factored into rising oil prices, there's no question that the commodity is vulnerable to a decline. Crude futures hit a record $48.70 a barrel on Thursday, up almost 50% since the start of the year. Still, Dan Rice, manager of State Street Research Global Resources fund, believes there's little risk for long-term players.

"Stocks are discounting $25 to $28 oil," he said. "But the futures market through 2010 is telling you long-term prices are $36 or $37."

Even if crude prices fell 15% to 20% from current levels, the price of oil will still be much higher than analysts or most of the major oil companies have predicted for the year.

"Theoretically, oil could come down to $40 or $38, and earnings estimates are still going to have to go up," said Chris Edmonds, director of research at Pritchard Capital Partners and a contributor to


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Edmonds conceded that a significant drop in oil prices would hurt the energy sector over the near term, but he said the longer-term trends still look bullish. William Ferrer, president and director of research for W.H. Reaves, agrees.

"When the price of oil falls, which it should, these stocks should fall," he said. "But we are not short-term trading investors ... and even if the price of oil fell $15 a barrel, it would fall to a level that far surpasses the economic expectations of these companies."

Ferrer said he remains "very positive" on the energy patch, not only because these firms are very profitable but because they're also "shareholder friendly."

"They've taken some of the cash flow and passed it on to shareholders in the form of regular dividend increases and almost incomprehensibly large share-repurchase programs," he said. "These companies are making a lot of money and have more profitable investment opportunities than they ever would have dreamed."