The counterintuitive case of oil stocks

WWhenever I look at the markets, I always try to remember the principle behind Occam’s razor, that the most obvious answer to a question is the most likely to be correct. If he walks like a duck and quacks like a duck, he’s probably a duck. If everything indicates that a stock is going to go up, it is probably going to go up, and if everyone thinks something is going to go down, it is likely to go down.

Sometimes, however, no matter how hard I try, I just can’t buy into the mainstream thought. This is how I feel about certain oil stocks right now.

The case against oil stocks in general is very well known. Ultimately, it is an industry in the process of disappearing, the inevitable march towards alternative and renewable energies accelerating in recent years. Fossil fuels are dirty and harm the planet. We must and we will move on from them. In the short term, this development is expected to accelerate, as we now have a White House administration that has taken on the challenge of tackling climate change. All of this is true, obvious, and high profile. So why buy anything related to oil?

First of all, if your objection to investing in oil is moral or ethical, I am not here to change your mind. On the flip side, if your objection to investing in oil is more about broader industry trends, let’s see why we might want to rethink that.

The first is to consider the time horizon of your investments. If you are generally someone who buys things, forgets them and leaves them in your account for decades, you would indeed be stupid to buy anything oil related. However, if you buy stocks with a strategy in mind, watch their progress, and when your end goal is reached sell and move on, you might want to consider investing in oil. Yes, the oil will be replaced, but that is unlikely to happen in the next year or so. And in this period, the sector’s shares may rise significantly.

The Biden administration is the opposite of the previous administration in terms of its attitude towards energy and the environment, and it is doing what it can to slow or reverse the massive boom in US oil production. What is not certain is the effect that these so far limited actions will actually have on companies in the sector.

What we’ve seen so far is a lot of talk and a few symbolic gestures, like joining the Paris Climate Agreement. This is an important gesture, because the adhesion of a country historically leader in the consumption of oil is essential to fight against climate change, but that does not change anything for the moment. There have also been a series of executive orders that target fossil fuels, but they only underscore why I think some oil stocks are heading into a boom time.

Admittedly, the administration canceled the approval of the Keystone XL pipeline and suspended drilling permits on federal lands and offshore. These are the only concrete actions having a direct impact on the American oil companies contained in the fact sheet. information from the White House, to my knowledge. There are a lot of lofty goals, task forces, and committees, but there’s really not much the White House can do. And what they have done so far is likely to have the effect of pushing up oil prices, while doing little or nothing to restrict production in the short term.

The Keystone XL pipeline is primarily intended to transport Canadian oil to refineries in the southern United States, so its shutdown will reduce competition for American drillers. The ban on new federal leases looks bad, but will actually have very little effect. Oil and natural gas from federal lands made up just 9% of total U.S. production in 2019, according to a CRS report, with the vast majority of U.S. drilling being state controlled. Environmental restrictions will make further expansion of U.S. oil difficult, but production was at record highs before Covid forced temporary shutdowns and may rise again quite quickly as wells that have already been licensed will reopen.

So we have a situation where competition is reduced and future supply will be limited to the margin, just as demand increases and production from existing wells picks up to meet this demand. To me, that means prices rise as supply increases, a perfect storm for US oil exploration and production (E&P) companies. And yet, despite this logic, the shares of these companies, firms like Diamondback Energy (FANG) and EOG Resources (EOG), have fallen in a knee-jerk reaction to what appears to be bad news. They are available at a reduced price, at a time when the outlook is good.

In this case, apparently, what looks and does look like a duck is, on closer inspection, quite another thing.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Felix J. Dixon