Will Oil & Gas Stocks Rise Again?

While this month has been a text book example of “Sell in May and go away” for commodity stocks, this year has also been a text book example of how consecutive black swan events remind investors of all the types of risks associated with investing.  There is no doubt about 2011 being a challenging year for investors, particularly the DIY investor, as it is charged with air pockets guaranteeing a rocky ride not many stomachs can handle. Although we are still in the middle of the year, chances are it might get worse before it gets better.

Why would anyone believe in energy stock prices rising again when current sentiment is tilting towards pessimism? Aren’t investors moving into defensive stocks? Yes but just as it is very hard to imagine winter’s sub-zero temperatures returning while you sit outside in a hot summer day it is just as hard to imagine these stocks rising again. However, winter ends up showing and these stocks will end up recovering and I expect they will start rising again as 2011 Q3 reports get released.

I believe what we are seeing in the market is a reaction to 3 variables: volatile oil prices, European debt and the uncertainty of QE2 ending. In my opinion, these 3 variables will prepare the ground for my scenario to materialize triggering the next leg up in energy stocks. This summer will provide a breathing space for all these variables to run their course.

Oil Prices are the Key

Even though I have always advocated high oil prices, I was never a fan of $100+ oil simply because this level would strangle the golden egg laying goose.  Oil prices above the $80 mark ensures future supply continuously meeting a growing demand as sources of hydrocarbons become more expensive to reach thanks to deeper wells and higher risks involved. Let’s not kid ourselves, the era of cheap oil is over but we’re not at the stage where $140 oil is warranted and this has been voiced by several OPEC members this year.

The recent elevated oil prices are starting to show up in the latest stream of economic data in the form of a slowdown in the US economic recovery. It also triggered inflation fears in emerging markets, after all oil directly or indirectly impacts all sectors of the economy. Stock markets have been reacting to this disappointing data by moving lower.

As Oil prices pushed higher, an inflection point was crossed whereby the higher oil prices rose, the lower junior oil and gas stock fell. Commodity and stocks were decoupled because the market had been pricing the negative impact of high oil prices as they rose. However, now that a correction in commodities have begun and is most likely to continue in my opinion, oil prices will be given the time to settle down in a comfortable range of prices while many speculators sit on the side licking their wounds given the recent beating they received. I do not expect prices to go lower than $80 because many OPEC members like Saudi Arabia have break even prices in this range. Unless we double dip, $80 to $90 barrel of oil will support a growing recovery, keep the markets well supplied and return decent profits to producers.

In my scenario, I expect oil prices to settle down this summer with the effect of lower oil prices showing up in Q3 economic data. At the same time, companies will be reporting decent profits at a price level they already used in their budget projections. As usual, it will suddenly dawn on “investors” that these companies are still profitable and given healthy fundamentals for oil will jump right back into energy stocks.

QE2 Uncertainty

We know that QE2 is ending as stated by the Fed Chairman Bernanke on April 27. While I believe the Federal Reserve will have to keep lending rates very low in order to support the recovery, I would like to see how he intends to do this. The Fed did announce it will continue to reinvest the proceeds from maturing securities even after QE2 expires and that the level of easing will remain steady. The end of QE2 is another psychological wall investors will have to climb over. There’s a danger the end of QE2 might trigger a real “correction” in the stock market which in my opinion would be a buying opportunity as long as the recovery is underway even if at a slower pace.

Final Thoughts

Maybe, if we’re lucky, by the end of the summer Greece would have done something about their debt: outright default, debt extension, selling of private assets or soft restructuring. Portugal just got bailed out and hopefully we don’t get to hear from any other European periphery countries.

I am keeping most of my core holdings and my dividend payers and look to resist playing the market timing game by simply keeping my focus on the fundamentals of my companies. If the market does go lower substantially, I most probably will be buying as I believe that in the end we will recover simply because we cannot afford not to.