What are we to make of the rapid decline in oil prices from over $147 to under $120? I have been a long-time bull on oil and commodity prices, and a bear on the financials. Is this trade, which has been so profitable over the last few years finally over? Is it time to reverse course? I think not.
The key reason for the decline in oil (and other commodity) prices recently is due to spreading economic weakness around the globe. Japan has indicated that it is falling back into recession, Western Europe is weak, and there are even indications that China's growth is slowing (although to a rate that any other country would envy, like to 9.0% or so). There has been relatively little happening on the supply front.
The oil market is one that has very inelastic curves for both supply and demand. This means that small shifts in either can lead to large price changes. All indications are that the changes are mostly on the demand front. In the U.S. drivers have cut back on the number of miles they drive by about 3%, and they are starting to drive in more fuel-efficient ways. They are even starting to check their tire pressure! Contrary to some assertions of the political chattering class, that actually makes a difference, and a difference that is felt today, not seven years from now like increased offshore drilling might.
A major question is, if part of the cure for high prices has been high prices, i.e. $4 a gallon gas has forced people to change their behavior, will lower prices again cause higher prices? Will people start to take their big SUV's out of the garage again? Will they start to accelerate quickly away from the stop light again? Probably not immediately, but in time they will. We will become accustomed to the current slightly lower prices and go back to our old ways.
We have started to see some of the structural changes in the economy that are needed to cut into energy usage in a rational and relatively painless way. Sales of big SUV's are down, while there a long waiting lists for more fuel-efficient vehicles. However, given the size of the overall fleet, these changes will have to be sustained for several years to make a real difference.
While China may be slowing slightly, the growth there is not going to come to a halt, nor will it in India. There have been no major breakthroughs on the supply front and the incremental oil is still going to come from very expensive and difficult places. With growing demand and limited supply over time, some of that demand has to be destroyed.
High prices are the great destroyer of demand. To the extent that demand can be destroyed relatively painlessly (i.e. proper tire inflation, switching to more efficient light bulbs) it reduces the need for demand to be destroyed painfully (people freezing to death in New England this winter, starvation in the third world). However, one way or another demand will be destroyed. Honestly, I do not know which direction the next $10 in oil prices will go. However, I am extremely confident that the next $50 move in oil will be to the upside.
Demand for a given commodity like oil can also be destroyed by substitution. There needs to be more of that, and high oil prices will help drive that process. As that happens, those alternatives will do very well. For the more speculatively inclined the solar companies look like very interesting bets. Some of the ones we like include Energy Conversion Devices (ENER), Evergreen Solar (ESLR), Sunpower (SPWR), First Solar (FSLR) and JA Solar (JASO). However, these stocks have high P/E's and represent more the potential of huge future earnings than the current reality of big earnings in the here and now. Going with a package approach, buying small positions in several of them or using an ETF that specializes in the area might be a good way to invest in these.
Also don't forget the old fashioned alternative to oil -- coal. One thing that China is likely to seriously ramp up its imports of is coal. Arch Coal (ACI) and Peabody (BTU) look very attractive to us.
Those that own big pools of oil (and natural gas) in the ground will also be big winners, as will those who provide the expertise to find and extract that energy. These firms have the advantage of being extraordinarily cheap, especially as many of them have sold off in response to the recent decline in oil prices.
If one were to treat the entire energy sector of the S&P 500 as a single stock, its P/E is far lower than that of any other sector. The total market capitalization of the Energy sector is only 9X the total expected earnings for the sector in 2008, and only 8x the total expected earnings for 2009. Note that the P/E is lower for 2009 than 2008. That means that 2008 IS NOT the earnings peak for the Energy sector. A few of our favorites include Baker Hughes (BHI), Core Labs (CLB), ConocoPhillips (COP), Diamond Offshore (DO), EOG Resources (EOG), Grey Wolf (GW), Transocean (RIG) and XTO Energy (XTO).
Read the full analyst report on ENER
Read the full analyst report on ESLR
Read the full analyst report on SPWR
Read the full analyst report on FSLR
Read the full analyst report on JASO
Read the full analyst report on ACI
Read the full analyst report on BTU
Read the full analyst report on BHI
Read the full analyst report on CLB
Read the full analyst report on COP
Read the full analyst report on DO
Read the full analyst report on EOG
Read the full analyst report on GW
Read the full analyst report on RIG
Read the full analyst report on XTO
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