What to Watch When Trading Oil Stocks

What to Watch When Trading Oil Stocks

What to do with US$110 billion in cash.

This is the problem Warren Buffett carries to work each morning.

Granted, it’s not a dilemma you or I are likely to have.

But his company Berkshire Hathaway has so much money they can’t quite work out what to do with it. There are precious few cheap businesses with a bright outlook left to buy after a nine-year bull market.

Buffett and Berkshire are so rich that only huge companies can enter the crosshairs of Buffett’s elephant gun.

Let’s pretend for a moment we could command that kind of money.

What could we do with it?

Well, there’s one huge industry that could accommodate all this and more.

Free cash flows as Brent crude stays high

Buffett has been historically averse to commodities over his long career, with the exception of a poorly-timed foray into silver years ago.

Commodity stocks offer little competitive moat and usually require lots of capital reinvestment to keep going.

But the big oil stocks are starting to spew free cash and are largely swearing off the big money-hungry projects of yesteryear.

Major Russian producer Rosneft, for example, just reported that net profit for the second quarter more than trebled. Meanwhile, profits for Petrobas in Brazil are up thirtyfold over the last year.

Granted, Buffett has a preference for US companies. But that still leaves stocks like ExxonMobil and Chevron to consider.

It may be just me, but isn’t it curious how oil has barely budged considering the heady trade war rhetoric lately? Gold, copper and zinc are all down badly. Not so for the black gold.

Granted, we are in the traditionally strong period of the year for oil as the Northern Hemisphere goes on holiday — and goes driving. But events are shaping up to keep the oil bull market going.

Saudi Arabia — depending on which data source you cite — is said to have actually cut production again in July. This comes after their previous guidance of increasing production in June.

And we still have the ongoing crisis in Venezuela. Production there is now below 1.5 million barrels a day.

It was over two million as little as two years ago. Now the state-run oil company is being forced to use leased neutral tankers to avoid the threat of seizures.

But the headline supply and demand numbers are now secondary to what happens with middle distillate growth.

The hidden problem forming in the oil industry

These are the products that typically receive less attention: diesel, jet fuel and heating oil.

Supplies of diesel are tight. The US Energy Information Administration reported recently that, at the end of June, inventory levels of diesel and heating oil were at their lowest point since 2004.

This is despite the fact that US refineries are running at record levels.

We can take the hint easily enough: Demand is rock solid.

This, in turn, should keep refiners bidding for the input they need to churn out these products: crude oil!

God forbid there is any further supply disruption because there’s precious little spare capacity left in global oil markets.

Yet there’s a hidden problem building within the entire sector too.

The only sector in the ‘upstream’ part of the oil industry (i.e. exploration/development) receiving prodigious capital investment is short-cycle US shale.

This oil — while welcome — is less useful for producing the middle distillate products that are in such hot demand.

The very best of the light, sweet crude that is excellent for producing diesel actually trades at a premium to the mainstream benchmarks usually quoted. That’s because it’s relatively hard to source. Most of the world’s oil supply is heavy and sour.

One suggestion for Saudi Arabia’s lower production in July is that buyers were rejecting the crude because of the asking price.

What we don’t know is what type of crude was for sale. There are different grades that the Saudis produce.

But it’s a possible clue that it’s not an overall shortage of crude driving the market right now, but rather the structure of refining demand.

That naturally puts global growth right back in the spotlight. A strong economy will keep driving diesel demand; a weak one will knock it down.

The result is going to be binary: either diesel demand weakens and takes the heat off the oil market or oil rises as these middle distillate supplies become stretched.

My view is the latter is more likely to occur. This puts oil stocks right in the spotlight over the next 18 months.

The right strategy for investors is probably to invest in more than one stock. After all, each oil company carries individual risk specific to its production. For example, a hurricane in the Gulf of Mexico could knock down a rig.

You want to negate this kind of risk as much as possible, while benefitting from the potential for oil to surge.

Should the global economy continue to fire, a basket of oil stocks acquired now could make for a very interesting 12 months to come.

I’ve got two on my buy list right now, with more in the pipeline.


Callum Newman Signature

Callum Newman,
Editor, The Daily Reckoning Australia