There are many instances in the life of an investor when the stock market appears to be toying with you. It dangles in front of you what looks like an obvious opportunity and dares you to take advantage. We have to decide whether these occasions are, indeed, opportunities or whether the market once again is trying to steal our money.
With stock markets at new all-time highs and many stocks and sectors trading at relatively high valuations, we look for value in beaten up, out-of-favour sectors where the future gains look attractive relative to the risk being taken.
One such occasion might be upon us now. As most investors are aware, oil has been in a bear market for the 3 years since reaching $110 per barrel in the summer of 2014. As the chart below illustrates, the bear market low was reached in February 2016. The rally off the low was strong and oil rose from $28 per barrel, to $50 per barrel, by June 2016. Since then oil has traded sideways between $40 and $55 per barrel. The recent price advance above $55 per barrel was highly significant, as it finally broke through oil’s long-term downtrend to reach $57 per barrel. This is a level not seen since July of 2015. After many months of failed attempts to begin a new bull market, has it finally been able to turn the corner and provide investors some long-awaited relief?
Fundamentally, there are many reasons to think a longer term recovery in oil is at hand. OPEC has instituted a production quota among members that appears to be holding.
• US shale production is leveling off
• World crude oil inventories are declining
• Global demand is recovering with synchronized global growth.
The key to the opportunity at hand is to ask how oil and gas stocks have performed relative to the price of crude oil. The answer is they have underperformed quite badly, with a relentless series of false recoveries, and lower lows and lower highs. Investors are so tired of being fooled. Investors are not in the mood to re-purchase oil stocks, even as the commodity looks to finally be turning the corner. Indeed, investors have continued the selling pressure into July and August even as the price of crude was recovering from its low in June.
Let’s look at where some producers are at the time of writing this article compared to where they were the last time oil was priced at $57 per barrel. Baytex, now $3.99, was priced over $18. Crescent Point, now $9.98, was priced over $25. Cardinal Energy, now $4.81, was priced over $14. Ensign Energy, now $6.05, was priced over $12. And the list goes on.
The under-performance of these stocks relative to the recovery of the commodity is a classic example of investor fatigue. Herein lies the opportunity. The potential gain for many of these stocks is 100% or more. For investors who believe that oil is in the early stages of recovery and can look through the short term volatility, a renewed uptrend in oil could result in a surprisingly strong rally for oil stocks. After such a long and deep bear market, investors have forsaken the industry. Most of the institutional players are underweight or have no exposure to the sector. It may take a few months for sentiment to change, but when it does it will turn quickly.
