Summary

• Oil is extremely oversold and due for a rebound.
• Oil consumption remains strong and is likely to increase thanks to cheaper prices.
• Historically oil rebounds quite quickly, especially when the U.S. and global economy are growing.
• Investors are overly negative on oil ever since the OPEC meeting, but production cuts could still be on the way.

Ever since the November 27th OPEC meeting the price of oil has plunged by about 20% and many stocks are off by much, much more. The doomsayers and shorts are out in force now, emboldened by the weakness in this sector. There is a tremendous amount of negative sentiment towards oil now. But this extreme level of negativity appears to be very overdone. It also seems to be based on psychology, forced margin call selling, panic selling and tax-loss selling. With all these factors, it’s been a perfect storm that has brought some small-cap oil stocks back to levels not seen since the depths of the financial crisis. Back in 2009, oil plunged to the $40 range, but the U.S. and the global economy were in free fall and oil consumption was also falling. The factors that drove oil to collapse in 2009 like bank failures, financial system imploding, home prices collapsing, massive layoffs, and other negatives that just do not exist today. That is why it does not make sense to be expecting oil to plunge back towards the lows seen in 2009. Furthermore, it is really important to realize that even when oil plunged in 2009, it rebounded very, very quickly (in spite of all the doomsayers back then). That is another big factor to consider because since the global economy is significantly stronger now, it could rebound sooner than most investors realize. Here are a few more reasons why this is a buying opportunity as oil is not likely to go down much more and why it is not likely to stay down for very long:

Reason #1: Energy company insiders are calling the recent plunge in stocks a “fire sale” and they are buying at a pace that has not been seen in years. Oil industry insiders have seen the ups and downs in oil prices and have experienced market pullbacks before. If oil company insiders are buying en masse now, there is a good chance that they see bargains and a strong future for oil. This supports the idea that there is a disconnect between the current market price of many oil stocks and the longer-term fundamentals of this industry. Citigroup (NYSE:C) recently made a strong case that indicates there is a disconnect between asset prices in the oil industry and the fundamentals. A Bloomberg article details some of the recent insider activity, it states:

“This is an absolute fire sale,” he said. “It’s an overreaction and the result is it’s oversold.” With valuations at a decade low, oil executives such as Rochford and Chesapeake Energy Corp.’s (NYSE:CHK) Archie Dunham are driving the biggest wave of insider buying since 2012, data compiled by the Washington Service and Bloomberg show. They’re snapping up stocks after more than $300 billion was erased from share values as crude slipped below $70 for the first time since 2010.”

Reason #2: Just because OPEC did not act at the November 27th meeting, it does not mean they won’t act. OPEC is scheduled to meet again in 2015, but there is always the possibility for an emergency meeting at any time. Even a statement from OPEC discussing the willingness to cut production or to address “cheating” by some members who are producing more than their quota allows could cause a significant short-covering rebound in the oil sector. A CNBC article points out that some industry watchers believe OPEC could act soon with an extraordinary or “emergency” meeting, it states:

“We see the possibility they call an extraordinary meeting sometime next year,” said Dominic Haywood, crude and products analyst with Energy Aspects. “We think they’re going to address countries not living within their quota.” OPEC has a quota of 30 million barrels a day, but it has been producing more.

On December 2, a Saudi Prince stated that his country would cut production if other countries would also participate. This seems the first “olive branch” since the OPEC meeting and it appears to be in response to the slide in oil since that meeting took place.

Reason #3: The perceived “glut” of oil is much smaller than most people realize. Furthermore, that excess supply could be taken out rather rapidly because cheaper oil is likely to lead to more demand and consumption. Toyota (NYSE:TM) just reported that sales of its 4Runner sport utility vehicle just jumped by 53% in November and sales of the Prius fell by 14% in the same period. This is just one example of how quickly demand for oil can rise and if you multiply even slight increases in global oil consumption because of much lower prices the numbers get quite large. Urban Carmel (a former McKinsey consultant and President of UBS Securities in Asia) believes that oil is going back to $80 per barrel and a recent article he wrote explains why the perceived glut is not going to last long, he states:

“Excess oil supply (over demand) is presently about 1 mbd. That would be a problem for oil prices except for one thing: existing fields lose about 6% of their production capacity each year, equal to about 5.5 mbd. That means that even if demand is flat, at least 4.5 mbd in new production is needed. Opec has spare capacity of only about 3 mbd. The remainder must come from new investment. New deep water and oil sand projects have a breakeven cost of about $80-90. There will be little incentive to make these investments unless the price of oil is at least $80. If the price stays lower than $80, supply will be insufficient for demand. It’s exactly under those circumstances that spikes higher in oil prices have occurred in the past.”

Reason #4: Oil can be very volatile, but it historically rebounds very quickly because it is used in very large quantities every day. The chart below shows that oil has reached a level that is giving investors a buy signal. Also, it is worth noting that prior oil price slides typically lasted about 20 weeks and the current slide is on week 25 which is another sign a rebound is way overdue. Oil and most oil stocks are extremely oversold now and that means a powerful relief and short covering rally could be coming soon. Some “smart money” investors are recognizing the buying opportunity at hand. Hedge funds are starting to position for a rebound in oil as there is a growing belief that the oil slide has run its course and is now due for a rally.

Oil is already down by about 40%, and the global economy is not in a current state that would support drastically lower prices as some are predicting. It is worth noting that most analysts and economists have a terrible track record when it comes to forecasting oil prices. If you had told anyone that oil was going to surge to over $100 within a couple years of the financial crisis you would have been ridiculed. I believe that the inaction at the OPEC meeting triggered margin call selling, and as we know, selling begets selling especially at this time of year when tax-loss selling fuels even more downside pressure. Some investors are making too much of the oil price decline by trying to connect the dots which should not be connected. I don’t believe that oil’s decline is a major sign of global economic weakness, I believe it is partially because supplies are temporarily a bit higher than needed, the dollar has been strong, and because too many speculators held futures contracts that were suddenly liquidated after the OPEC meeting sparked a sell-off. This has created bargains, especially in small-cap oil stocks. I have been primarily focusing my buying on companies that have no direct exposure to the price of oil and significant contract backlogs. This has led me to buy stocks like McDermott International (NYSE:MDR) which is now incredibly cheap at less than $3 per share. This company is an engineering and construction firm that specializes in the energy industry. It has a $4 billion contract backlog and it has about $900 million in cash and (incredibly) a market cap of just $584 million. That means that this company could buy all the outstanding shares and still have over $300 million left in cash on the balance sheet. McDermott shares are also trading for less than half of the stated book value which is $6.30 per share. On November 14, David Trice (a director) bought 20,000 shares at $4.16, which was about $83,000 worth of stock. But, due to immensely negative sentiment in the oil sector, panic selling, margin call selling, and tax-loss selling, this stock is down by about 40% just from when this insider bought, even though this company has no direct exposure to oil prices and enough business (with the $4 billion+ contract backlog) to keep it busy for the next two years. It also does projects for the natural gas industry and investors seem to have overlooked that natural gas prices have remained solid.

I also see opportunity in Willbros Group (NYSE:WG) which trades for just over $4 now (down from a high of about $13 this year). It specializes in pipeline projects for the energy industry which includes oil and gas, petrochemicals, refining as well as electric power. This stock took a hit several weeks ago when the company announced it would restate earnings due to a charge on a pipeline project that was estimated to reverse about $8 million in previously reported pre-tax income. This caused the company to be delayed in filing the latest financial report and the market overreacted by knocking off about $160 million in market cap in just a few days after the restatement issue was announced. Willbros Group has a strong balance sheet and a $1.7 billion backlog which absolutely dwarfs the restatement numbers and the market cap of just about $215 million. It also recently announced plans for an asset sale that is estimated to generate up to $125 million. For more details, read my recent article on Willbros Group.

I expect that small cap stocks like McDermott and Willbros will rebound as tax-loss selling should fade by December 19th which is the Friday before the holiday season. This causes most traders and investors to have completed their tax planning issues before taking off for the holidays and that often leads to a significant “Santa Claus” and “January Effect” rally in beaten-down small caps.

Keep An Eye On Futures

Oil Futures Structure Seen as Encouraging Traders to Store Crude. 

By Mohammed Aly Sergie

Brent oil in a contango will encourage traders to take delivery of crude and wait for higher prices, according to U.S. economist Dennis Gartman.

Brent for February delivery is $6.10 a barrel cheaper than the February 2016 contract. February Oman oil traded on the Dubai Mercantile Exchange is $8.30 cheaper than the year later contract after being $6 more expensive about six months ago.

“Not enough people pay attention to the importance of term structure,” Dennis Gartman, author of the Suffolk, Virginia-based Gartman Letter, said yesterday in a phone interview. “The market is saying it will pay traders to go into storage.”

Gartman said contango arbitrage is easier to trade on the broader benchmarks than the Oman contract because banks prefer to provide financing for markets that are more heavily traded. Investors can earn a “nearly riskless return” of 8 percent by selling crude futures and storing oil at current prices, Gartman said.

The cost of warehousing and lending has hindered popularity of the trade, Gartman said. Shipbroker Charles R. Weber said this month that oil tanker rates are too high to spur floating storage. There are 28.8 million barrels of oil being stored at Cushing, Oklahoma, about three million barrels above the 2014 average.