Why are oil stocks so undervalued right now?

Lately, the oil bulls are just not getting a proper break. Just as oil prices were consolidating after OPEC + struck a deal on production quotas, markets are in free fall again. Oil prices are set to experience their worst trading week in more than nine months after the latest EIA data showed U.S. crude stocks unexpectedly surged sharply last week, with stocks of crude showing a construction of +3.6 million barrels against a consensus of -3.1 million, and – 4.1M the previous week.

But it’s not just growing US stocks that have destabilized the markets. News that the COVID-19 Delta variant is rioting in China does not bode well for global markets.

West Texas Intermediate oil fell to $ 67.85 a barrel on Wednesday, about 8% below the close on Friday.

As usual, as energy prices move, energy stocks generally follow suit.

The global benchmark in the energy sector, ETF Energy Select Sector SPDR (NYSEARCA: XLE), is down a relatively small 2.4% over the past three sessions.

However, other energy funds are not so lucky, with the US Oil ETF (NYSEARCA: USO) down 7.0% in the past three sessions while the VanEck Vectors Oil Services ETFs (NYSEARCA: OIH) and ETF ALPS Alerian MLP (NYSEARCA: AMLP) slipped 6.0% and 3.6%, respectively.

Note: USO is different from OIH, XLE, and AMLP in that it invests in oil futures rather than stocks.

That said, what’s surprising is that despite the recent massive sell-offs, energy stocks are still among the top performers this year.

XLE is up 28.0% year-to-date, topping the S&P 500 Index by more than 10 percentage points.

USO has jumped 43.0% year-to-date; OIH is up 16.3%, while AMLP gained 27.4% over the period.

Yet many investors will be surprised to find that despite these overwhelming market gains, oil stocks have actually dragged oil prices by a significant margin this year.

Cheap Oil Stocks

The price of WTI crude oil has climbed about 45% year-to-date as many economies reopened amid rising vaccination rates and billions of dollars in fiscal stimulus pouring into them. markets.

According to Citigroup analysts, gains in oil stocks should be stronger than that given historical trends.

Note that the prices of oil itself are still very cheap compared to another major commodity, gold, as we have pointed out here.

In a recent research note, Morgan stanley Martijn Rats and Amy Sergeant said that although the oil-to-gold ratio has always been a poor indicator of future oil prices, it may still be of interest to investors seeking advice on the direction of oil prices.

So how is this trend?

Related: US Auto Makers Consider Massive Increase in Electric Vehicle Sales

We can go back and see how many barrels of oil a single ounce of gold could buy at any one time, which is barrels per ounce.

The long-term average gold-to-oil ratio was that one ounce of gold would buy 16.53 barrels of oil. Anytime an ounce of gold bought more than 16.53 barrels of oil, it meant that the oil was cheap or the gold was expensive. Conversely, oil was considered expensive or gold cheap whenever an ounce of gold would buy less than 16.53 barrels. Knowing this can help investors determine whether they should buy more oil and sell their gold, or vice versa.

On this basis, oil prices would need to climb to around $ 110 / bbl for the gold-to-oil ratio to return to its historic median. As a result, Bank of America’s recent prediction that oil prices could reach $ 100 a barrel in 2022 doesn’t seem so far-fetched.

And it also means that oil stocks could have even greater upside potential than current oil prices suggest.

Lower forever?

Either that or we need to recalibrate our expectations for oil prices.

Like Shell (NYSE: RDS.A) CEO Ben van Buerden warned a few years ago that the oil industry could have entered an era of “Lower Forever” mainly due to the green energy transition, climate mandates and growing government policies. hostile.

However, these are long term headwinds with time horizons of 10, 15 or maybe 20 years.

With key renewable energy sectors such as electric vehicles and solar power themselves facing formidable challenges, the oil bulls still have the upper hand.

By Alex Kimani for Oil Octobers

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Felix J. Dixon