The S&P/TSX Energy Index continues to hover well above levels indicated by the West Texas Intermediate crude oil spot price. Longer term futures prices suggest this is a reasonable bet, but there's not a lot of room for error.
The first chart makes energy stock holders look certifiably insane. For much of the past five years, energy stock values in aggregate trailed the levels implied by the commodity price. Since November, however, the energy index has remained stubbornly stable despite further declines in oil. Crudely following the trend in the chart, the current $55-ish WTI price (in Canadian dollars) suggests the index should be 50 per cent lower.
SOURCE: Scott Barlow/Bloomberg
The current commodity price is not the whole story, however, and the second chart explains the gamble current holders of energy stocks are taking. In a previous post, I detailed former Goldman Sachs Group Inc. economist Jim O'Neill's belief that the best leading indicator for oil prices is the five year future price. Mr. O'Neill's rationale is that there are rarely speculators in futures contracts of that length, and the oil producers who dominate the five-year market have a better handle on the industry's future.
SOURCE: Scott Barlow/Bloomberg
Domestic energy stocks are roughly in line with the five-year WTI future price of $84 (Canadian) per barrel. This makes sense if we remember the conventional way to value an equity – the discounted future value of cash flows. Current stock holders are assuming that the commodity price will average something in the neighborhood of $80 in Canadian dollars over the next five years. And, if that happens, the cash flow generation between now and then justifies current valuation levels.
The risks – that the five year future price will turn out to be a poor leading indicator and the oil price is much lower than $80 for the next few years – are obvious, but not prohibitive for the average energy stock investor at the moment.
The success of a long oil strategy will be determined primarily by the extent of supply cuts, which puts investors in the strange position of rooting for bankruptcies and shutdowns for companies they don't own. These events would cause short term weakness in the S&P/TSX Energy index, but would result in the production cuts necessary to end the ongoing glut in crude and support the commodity price.
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