Oil Price Correction

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Oil fell to nearly $55 before settling at just above $56 in New York. Oil has been officially Plutoed. “Plutoed” was the word of the year at the annual meeting of the American Dialect Society (which we’re sorry we missed this year.) It means to devalue or demote something, derived from Pluto’s relegation to mere celestial body when scientists decided it no longer qualified as a planet (scientists change their mind, you see.)

–But here’s our real question with oil: what do the markets know on this one that we don’t?

–As we pointed out yesterday, warmer temperatures don’t do much to reduce the demand for transportation fuels, and transportation fuels constitute the chief source of demand for oil. So why is oil falling?

–Dr. Faber has a suggestion. He points out that in long bull markets, corrections of 40% or more from a low base are not at all unusual. For example, the Dow Jones Industrials gained 276% between its March 1980 level of 729 and its pre-Crash August 1987 level of 2,746. By October 20th of 1987, the Dow had lost nearly 1,130 points to close at 1,1616. Back then, 1,000 points on the Dow meant something. The correction took the Dow down by nearly 41%.

–Of course that was a great buying opportunity. As Dr. Faber points out, it pays to be a buyer during a selling panic, if you have the money and the nerve. Since the ’87 correction the Dow has gone up nearly 1,000 points, if you use 12,445 as the high. During a secular bull market, a 40% correction is a dip—albeit a big one.

–So where would a 40% correction from its July ’06 high of $77 leave oil (using spot West Texas Intermediate prices, by the way)? Well, first keep in mind that in early December of 1998, a barrel of West Texas crude could b hade for just under eleven bucks. Form that base oil rallied 617% by July of last year. That is a good run. But the current correction has taken twenty-two bucks off the oil price.

–A full-fledged 40% correction in crude oil would but it back down to around $45 a barrel, another ten dollars from here. There is nothing magical about the 40% figure, but it does seem to repeat itself across market cycles over time. And we suppose that if traders get in a liquidating mood, we could very well see a crude oil price of $45.

–If that is the case, dear reader, we would be frothing at the mouth to buy oil stocks. Oil stocks have traded at stubbornly low price-to-earnings multiples throughout the bull market in crude. For example, ExxonMobil (NYSE:XOM) trades at just 11 times next year’s estimated earnings. British Petroleum (BP), trades at just nine times earnings. Chevron (CVX) trades at nine times, earnings too. And ConocoPhillips (COP) trades at just six times earnings.

–When investors refuse to pay more for record earnings (which the oil companies have been racking up) it reflects some serious doubt. In this case, the doubt is that oil prices will stay high and that earnings will continue to pour in. If investors were confident of higher oil prices tomorrow, they’d be willing to pay more today for tomorrow’s earnings.

–Just why the Street exhibits so little faith in the durability of rising oil prices completely baffles us. Arguing with the market is usually a bad idea. Stomping your feet and shouting “Idiots, all of you! Morons!” is not a trading strategy, though it might be gratifying. Instead, we would simply argue that the persistent doubt of the market concerning long-term energy prices is wishful thinking and not strategic investing.

–And yes, that means we’d be a buyer of oil and energy assets during the fall in crude prices. Today, GE (NYSE:GE) announced it agreed to pay US$1.9 billion for oil services company Vecto Gray. Who did GE buy from? A private equity fund, of course. More on that below. But as we said yesterday, now is a good time to be a buyer of quality energy assets.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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