Monday, October 10, 2005

Bubble, Bubble?

I must lead a sheltered life, since the first suggestion I've seen that anyone thinks oil prices and the stock prices of oil companies might be in a speculative bubble is this commentary from yesterday's New York Times thoroughly refuting the notion. Perhaps the experience of the late 1990s, combined with the current real estate boom, has us looking for bubbles everywhere, but I can think of few sectors in which this idea has less grounding in reality.

Mr. Stein hits most of the key issues, including the large cash flows and earnings of oil companies, their modest price/earnings ratios relative to the rest of the S&P 500, and the fundamental supply/demand issues facing the global industry. Anyone expecting an oil price collapse on the order of the mid-1980s will to have to be very patient, particularly since it would likely rely on a slowing global economy that would damage the entire stock market, not just the oil and gas stocks. Another point worth raising is the valuation mechanisms employed by equity analysts, who are so influential with the large funds and investors that drive much of the movement in these stocks.

Most analysts use models of oil & gas companies that are heavily weighted to assumptions about the future value of the commodities. These often differ from the market assessments reflected in the futures exchange. For example, the current analyst consensus is apparently for oil to fall below $60/barrel after 2007, reverting to something like $40. That's not unreasonable. However, Friday's closing price for crude in 2011 on the NYMEX was over $57. The disconnect on natural gas is also large. The consensus for 2007 seems to be around $7.50 per million BTUs, while the 2007 contracts traded on the exchange averaged $9.36.

Now, I've often argued that futures prices are poor predictors of future reality. But when you depart from them, you need to have a pretty good rationale for why you think things will turn out differently than the market expects. A market value for an equity that ignores the market-traded price of the commodity underlying that equity has a technical name: an arbitrage opportunity (though not a riskless one.)

When you put all this together, I believe you can make at least as strong an argument that the prices of oil and gas equities are undervalued, as that they are overvalued. That says they are probably about right, and in no way "bubbled up." I should mention that I still have a significant portion of my portfolio in oil stocks, including that of my former employer. That means I might be biased in my view of this. But neither am I liquidating those positions out of fear of an imminent collapse in value. My money and my mouth are in tune, here.

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