Oil Stocks Undervalued

Oil stocks have to be one of the most unloved sectors in the markets today. The recent general-stock-market and oil corrections combined with the incredibly-negative psychology spawned by the BP oil spill have driven oil stocks down to deeply-oversold levels. This swoon has also left this sector very undervalued, a barren wasteland strewn with great bargains for investors.

Valuations are classically measured by price-to-earnings ratios. P/E ratios reveal how much the markets are asking investors to pay for each dollar of profits a company earns. The lower the P/E, the cheaper the stock and the better the bargain. Buying a company at 7x earnings, which means paying $ 7 for each $ 1 of annual profits, is a far-superior deal to buying it at 28x earnings. It is much easier to achieve the first half of the buy-low-sell-high stock-trading-success equation if stocks are purchased at relatively-low P/Es.

Oil stocks generally trade at lower multiples (P/E ratios) than the broader stock markets. As the brutal stock panic ripped the markets to shreds in late 2008, 2007 was the last normal year before that epic discontinuity. The flagship NYSE Arca Oil Index is probably the best metric to use to measure valuations of oil stocks as a sector. Launched way back in August 1984 as the AMEX Oil Index, this price-weighted index comprised of 13 elite oil majors is considered the definitive measure of oil-stock performance.

Better known by its XOI symbol, this index had an average month-end market-capitalization-weighted-average P/E ratio of 12.3x in 2007. Meanwhile the broader S&P 500 (SPX), which also includes the large American oil stocks in the XOI, had a comparable average 2007 P/E of 20.2x. Thus the oil stocks were trading at about a 39% discount to the general stock markets over this 2007 baseline period.

At the end of last month as oil stocks languished along with the general stocks, the XOI sported an MCWA P/E ratio of 11.1x compared to the SPX’s 17.7x. This discount is only 37%, which is in line with pre-panic precedent and implies oil-stock valuations were slightly ahead of 2007’s average. Given this late-June P/E-ratio comparison, how can oil stocks be considered undervalued today?

There are other ways to gauge a sector’s valuation beyond P/E ratios, and these are where oil stocks look like a tremendous bargain. Oil stocks have two primary drivers, the oil price and the state of the general stock markets. Each of these drivers also offers an excellent alternative valuation metric, and these really reveal the widespread extent of oil-stock undervaluation today.

Stock prices are ultimately driven by profits, and oil-price gains naturally lead to leveraged increases in profits for oil producers. The higher the average oil price, the better the oil-stock profits, and hence the higher oil stocks will be bid by investors. Rising oil prices also generate excitement for oil stocks among traders, leading to increasing flows of capital into the oil-stock sector. So oil’s impact is obviously large.

But interestingly the general stock markets are another major driver of oil stocks, often eclipsing oil’s own influence. I did a study of XOI performance versus oil and the SPX a couple years ago that highlights this crucial fact. The large oil stocks of the XOI are so massive, with so much mainstream capital invested, that they mirror and often amplify underlying moves in the general markets. Even when oil is strong, oil stocks have a tough time rallying if the stock markets are weak.

Looking at oil stocks relative to either of their primary drivers today really drives home the great bargains to be found in this seriously-undervalued sector. The easiest way to quantify the relationships between drivers and the stocks they move is through ratio analysis. Ratios simply divide the sector driven (oil stocks in this case) by its primary driver. The resulting number charted over time reveals important tradable trends in relative strength and weakness.

We’ll start with the XOI/Oil Ratio, which is the daily close of the XOI oil-stock index divided by the daily close in oil (benchmark West Texas Intermediate crude). This ratio is rendered below in blue, superimposed over the raw XOI itself in red. Compared to oil, oil stocks are definitely undervalued today. Odds are high this valuation gap will close in the coming year, either by oil stocks rallying or oil falling.

Thanks to the stock panic and its aftermath, both the XOI and XOI/Oil Ratio (XOR) have been on a wild ride over the past couple years. Driven by record oil prices in early 2008, the XOI climbed to an all-time high of 1630 in May that year. Oil averaged $ 125 that month, before topping itself a couple months later at an astounding $ 146 per barrel. But as this ratio shows, oil stocks lagged oil’s terminal ascent.

The ratio hit a low of 9.6x on the very day in July 2008 when oil topped. Just like today, the ratio was far too low to be sustainable. Either oil stocks had to soar to reflect the higher prevailing oil prices or oil had to correct so the low oil-stock levels were justified. Back then, oil corrected as it should have. This commodity was wildly overbought at the time, trading 40% above its baseline 200-day moving average. For comparison the 2006 and 2007 average was less than 7%, and in April 2010 it peaked under 17%.

As oil corrected sharply (down 23% in the first 5 weeks) in the summer of 2008, oil stocks followed it lower but weren’t falling as fast as crude. Hence the ratio rose in Q3’08. Then when the terrible stock panic hit, oil stocks plunged with the SPX which again drove the ratio to unsustainable lows. But after the XOI bottomed in late November, oil stocks started recovering fast. This index’s initial rally was a blistering 31% in less than 4 weeks! Since oil was still drifting lower at the time, the XOR soared dramatically.

These abnormally-high ratio readings persisted until oil bottomed near $ 34 in February 2009. At that point oil started rallying significantly while the XOI sold off with the SPX into the latter’s infamous March 2009 despair lows. Ever since, during the strong SPX cyclical bull that was born then, oil stocks have been persistently lagging oil. While the giant XOI oil stocks were advancing with the general markets, they weren’t rallying as fast as oil which inexorably drove the XOR lower.

The result is the ratio downtrend rendered above. While the XOI managed to rally 49% at best since its panic lows, crude oil has soared 152% higher at best out of its own nadir. In the month before the SPX correction started in late April 2010, the XOR averaged 13.2x. The XOI was closing at around 13x the price of crude oil. This is actually on the low end of this chart, even if you ignore the anomalous panic spike.

At oil stocks’ best levels relative to oil since last summer, the XOR ran 15.5x in September 2009. This week, thanks to the devastated sentiment in the wake of the SPX and oil corrections and BP oil spill, the XOR was only trading at 12.3x. In order for the XOI to return to similar levels relative to today’s $ 76 oil price, it would have to rally 26% from today’s levels. But the extent of oil-stock undervaluation relative to oil runs well beyond this comparison.

In all of 2006 and 2007, the last baseline normal years before 2008’s wild panic volatility, the XOR averaged 17.9x. The XOI tended to close around 18x the price of crude oil. For the oil stocks to regain this historic relationship, the XOI would have to surge 45% above today’s levels! There is every reason to expect this relationship to normalize, as oil stocks play such a crucial role in both the world economy and investors’ long-term portfolios. Capital simply has to return to this unloved sector.

Now 26% to 45% gains in elite oil stocks are certainly enticing, but these projections are conservative on a couple key fronts. First, these are based off of oil prices staying stable at today’s $ 76. If oil continues rallying, as it is highly likely to as this SPX cyclical bull regains steam, the XOI targets quickly climb higher. Not only are higher oil prices plugged into the denominator of the ratio, but strong oil rapidly multiplies investor interest and hence capital inflows into oil stocks.

Second, smaller oil stocks are likely to really amplify the baseline XOI gains. Remember that the XOI oil stocks are the giants of the industry, majors with huge market capitalizations that have stock-price inertia much like oil supertankers. At the end of last month, the average market cap of the 13 XOI component stocks was $ 75b compared to the average SPX component size of under $ 20b. Smaller oil stocks have far greater potential to rally, and they could easily double or triple the underlying XOI gains.

While the undervaluation of oil stocks compared to oil is plenty compelling, even more so is their chronic undervaluation compared to the broader stock markets. The XOI/SPX Ratio (XSR) beautifully quantifies this. Incredibly, relative to the general stock markets oil stocks were recently trading well under their panic lows! There is probably no greater sector bargain today than these beaten-down oil stocks.

Back in early 2008 as oil soared towards $ 146, oil stocks rapidly advanced far outpacing the SPX gains. Of course the general stock markets were suffering in a new cyclical bear then, so the XOI’s relative strength was even more impressive. But once oil started correcting in July 2008, the oil stocks fell way faster than the SPX. This trend accelerated during the stock panic, when commodities stocks were hit disproportionately hard since mainstream money managers consider them to be exceptionally risky.

While the XOI bottomed in late November 2008 at the formal

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