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Op-Ed: Oil and Gas Stocks on the Edge of the Knife


A significant correction may occur in the near term.

Editor's Note: James Kostohryz was formerly the Head of International Investments for a major Brazilian Investment Bank.

The fundamentals for crude oil have rarely been worse. Inventories are near all-time highs and, as per today's EIA inventory report, continue to rise at a spectacular pace.

Production overcapacity is also on the rise. The capacity cuts in non-OPEC are being dwarfed by capacity additions in OPEC - particularly Saudi Arabia. This places a fundamental cap on oil prices in the medium term (1-2 years).

The demand picture is bleak. Global demand has been contracting at unprecedented rates, and I believe demand contraction outside of the US will actually accelerate in the second half of 2009.

The near-term fundamentals for natural gas are no better, with the only difference being that the poor fundamentals are more reflected in the price than in the case of crude.

Based on near-term fundamentals, crude oil should probably be below $40. In my opinion, crude oil is levitating based on speculative second-derivative spillover from the equity market, driven primarily by the crude ETFs.

I expect that at some point in the second quarter, we'll start to see some modest crude inventory draws in the US. I believe that this reversal could spark a speculative ramp that could take crude above $60.

If oil and gas stocks, particularly in the E&P space, ramp on such a move, I believe that they'll become good short candidates - perhaps in the June-August time frame. Currently, E&P stocks are pricing in crude prices of about $80, and gas prices are about 200% higher than they currently are in the spot market. Further increases in this group from current levels would create an unsustainable disconnect from short- and medium-term fundamentals. I'd stay away from the oil- and gas-producing stocks for this reason. They're way ahead of themselves fundamentally.

The most direct play on the above mentioned potential ramp in crude would be through the ETFs, such as USO, DBO, USL, UOY, OLO, OIL, DXO. The natural gas ETF UNG would probably rally in sympathy in the event of a crude ramp.

In terms of oil-related equities to look at, I prefer the oil service sector within the energy complex. The near-term fundamentals for the group are dismal, and I believe that current company guidance and analyst estimates are far too high. I believe guidance and analyst estimates will come down significantly in the next few months as lower-than-expected cash flows from oil producers cause further cuts in E&P budgets (note that virtually all oil producers that have reported thus far have significantly missed estimates).

The main attraction of the oil-service group in the short term is that valuations are already quite depressed and the group would likely get a major boost if oil prices could get above $60. $60 is the level at which most oil companies can afford to maintain their E&P budgets, or perhaps even expand them a bit. ETF candidates for the oil service and drilling sector would be OIH, IEZ, PXJ. My favorite individual stocks in the sector are Weatherford (WFT), Drill Quip (DRQ) and ION Geophysical (IO).

Currently, due to my medium-term concerns, the only oil-related equity I own is ION Geophysical.

I will reexamine my position on oil-related stocks if we see a significant correction in oil and oil related-stocks (as I'm expecting) in the next few days and weeks.

In memory of our fallen friend and trusted colleague, Bennet Sedacca, 100% of the donations made to the RP Foundation through April will be channeled to philanthropic endeavors consistent with the RP mission, working closely with the Sedacca clan in the distribution of those funds. We thank you kindly for your support as we strive to effect positive change in the lives of children.
Position in IO

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