Why The Market Is Wrong About Oil -- And How You Can Profit

By StreetAuthority | August 12, 2013 AAA

The duck-billed platypus defies all scientific reason.

This beaver-tailed, otter-footed, semi-aquatic creature is the only mammal on the planet that lays eggs instead of giving live birth. On top of that, it is the ONLY living representative of its family and species. Basically, the platypus is an inexplicable freak of nature. Although the platypus officially has no relatives, I have a theory that it may be distantly related to financial and commodity markets -- which often also look really weird and defy explanation.

Recently, I’ve noticed an odd disconnect between the price of oil and the performance of oil- and energy-related stocks. I’m no Dennis Gartman or Jim Rogers, so reading commodity price tea leaves is not my thing. But there's something going on -- and if there’s something quirky going on in the investment world, there’s an opportunity to make money.

Here’s an interesting chart of the one-year price action on West Texas Intermediate crude (WTI):

The spot price of this Texas tea is up 13% over a one-year period. Why? Good question. Typically, oil prices (and the prices of other commodities) rise when the U.S. dollar is weak. However, that’s not the case.

Although the greenback appeared a little weak at the end of last year, the dollar has spent nearly a year where the value currently sits with enough volatility in between to make some extremely coordinated traders some money. But for folks like us, there’s not much change.

As a whole, commodity prices are in a steady downtrend (I briefly examined the end of the commodity supercycle earlier this summer) -- except for oil. What gives? Like the duck-billed platypus, it defies explanation.

The New Oil Boom
Analysts and investment writers continue to chatter about the new U.S. oil boom. Thanks to fracking technology and recent discoveries, American energy security appears within grasp. The U.S. has become one of the world’s largest exporters (yes, exporters) of refined petroleum products.

However, a glut of global supply is inevitable. Economics 101 tells us that higher supply eventually results in lower prices, and the global oil supply is heading that way very quickly. Conventional logic would tell us prices should be lower or trending lower. They don’t seem to be.

Anecdotally, investors usually lift the prices of oil-related stocks as oil prices climb. This is happening, but only selectively. Some of these names are commanding unjustified premiums. However, there are a handful of oil-related stocks that have been mispriced or overlooked and offer extremely attractive value and profit potential (and some that aren't as promising).

Oil Patch Bargain Bin
Valero (NYSE: VLO): The world’s largest independent petroleum refiner and marketer trades at a nearly 50% discount to the price-to-earnings (P/E) ratio of the S&P 500 index. This $19 billion market cap player is benefiting from increasing domestic oil production, lower input cost and growth in U.S. refined product exporting. Shares trade at around $37 with a forward P/E of 9 and a dividend yield of 2.5%.

Petroleo Brasilerio (NYSE: PBR): Petrobras is Brazil’s (the B in "BRICs") national oil company. Although emerging markets have cooled recently, Brazil still remains an attractive opportunity thanks to its young and growing middle class. The downside is a weak currency and small pockets of social unrest. That aside, Petrobras has leveraged its large domestic reserves and exploration success to position the company as the dominant energy producer in Latin America. The stock looks cheap at around $14, a 43% discount from its 52-week high, with a forward P/E of 7.3 and a 2.6% dividend yield.

Phillips 66 (NYSE: PSX): Spun off from oil giant ConocoPhillips (NYSE: COP) last year, Phillips 66 was the refining and marketing arm of its former parent. Again, with the upswing in U.S. oil output, refining is the place to be. The company also holds significant assets in the natural gas liquids (NGL) space which, despite low natural gas prices, will be a growth are going forward. With a market cap of $36 billion, this big company looks downright cheap at around $59 a share with a forward P/E of 8.3 and a 2.1% dividend yield.

The Dry Holes
Halliburton (NYSE: HAL): While a legend in the oilfield services business and an insanely well-run company, it’s hard to get excited about shares of Halliburton. The stock price sits near its 52-week high at nearly $46. The forward P/E isn’t all that unreasonable at 14, but the dividend yield of just above 1% is miserly for a $42 billion company that generates over $4 billion in annual free cash flow. This is a valuation call. The price and the compensation just don’t justify ownership. In addition to the toppy price, too much legal risk remains from the Deepwater Horizon disaster fallout.

Schlumberger (NYSE: SLB): Another legendary name in the oil services business, Schlumberger, like its archrival Halliburton, looks a little expensive. Shares trade at around $80 with a forward P/E of 18 (pretty much equal to that of the S&P 500). The company is also stingy with its annual free cash flow of nearly $9 billion, paying out a measly 1.5% dividend yield. As with Halliburton, there's not enough incentive to own the shares. Schlumberger’s overreliance on drilling in the Gulf of Mexico can also be seen as a liability as activity in that region is growing at a slower pace due to increased activity in land-based exploration in North America.

Nabors Industries (NYSE: NBR): As the world’s largest land oil drilling contractor, it would seem that Nabors would be a no-brainer route to participating in the North American oil renaissance. Looking under the hood of this one tells me otherwise. Earnings growth is less than impressive. 2012 earnings per share (EPS) came in at 82 cents. Estimates for 2013 are for 85 cents a share. 3% EPS growth from the biggest player in a booming sector isn’t enough to get impressed by. Return on equity is also unexciting at just 4.2%.The 1% dividend yield isn’t that attractive either.

Risks to Consider: Oil prices have gone up, which means they are destined to fall sooner than later. Crowd psychology typically takes over, which means that the prices of oil related stocks should go down, too. The lower valuation metrics and decent yields on the stocks I like should help combat that movement. Also, keep in mind that we are about to enter the busy portion of hurricane season, this always has a negative impact on refiners due to their presence on the Gulf Coast.

Action to Take --> Collectively, the bargain basket of VLO, PBR, and PSX trade with an average forward P/E of 8.2 and a dividend yield of 2.23%. Modest P/E expansion of 25% -- going from a P/E of 7 to a still cheap P/E of 8.8 -- would result in one-year returns of 25% or better for the basket. Factoring in the dividend, potential total return would be north of 27%.

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