As oil flirts with $50 (U.S.) a barrel, investors are trading drilling stocks as if crude were selling for $80, and that's the kind of optimism that leads to corrections.
Legendary short-seller James Chanos said last week that he's considering wagering against explorers because they've gotten ahead of themselves. In the past three months, Denbury Resources Inc., SM Energy Co. and California Resources Corp. have all quadrupled in value as the price of oil rose by only about 50 per cent.
"The equities have really outrun the fundamentals," said Vincent Piazza, a Bloomberg Intelligence analyst. "The bullish factors people have been looking at – the OPEC-Russia freeze that didn't happen, Nigerian oil going offline, Canadian wildfires – are all more transitory than anything else."
Since hitting a 12-year low on Feb. 23, an index of North American oil and gas explorers has surged about 65 per cent, compared with the 51-per-cent rise in West Texas intermediate, the benchmark U.S. crude, according to data compiled by Bloomberg. U.S. natural gas has returned a relatively anemic 15 per cent increase during the same period.
"These stocks have come a bit far," Gordon Douthat, an analyst at Wells Fargo & Co., said in an interview. "The anticipation that this storage overhang is normalizing has driven these names well beyond what the commodities have done."
Shrinking supply
The record amount of crude stored in U.S. terminals ticked downward in the week ended May 6, the first decline in more than a month and just the fourth drawdown this year, according to the Energy Department in Washington. The one-week decline in inventories may signal that three straight months of falling production from U.S. wells is beginning to cure the oversupply that has weighed on crude markets for almost two years.
Gas inventories rose by 56 billion cubic feet last week to 2.681 trillion, more slowly than the five-year average gain of 79 billion for the period, according to a U.S. Energy Information Administration report.
Mr. Chanos, the founder of Kynikos Associates, said North American oil and gas exploration was unprofitable when crude sold for $80 and $100, and is "certainly not economic at $45 oil."
Closing shorts
Mr. Chanos closed out short positions in domestic oil producers in January and February – just as those stocks were bottoming out – and said he may renew those short bets to profit when the current rally collapses.
"A lot of those stocks have rallied up 200 per cent, 300 per cent, since mid-February," Mr. Chanos said in an interview last week. "They are starting to look interesting again. The stock prices have outrun oil. They are discounting in some case $60, $80 oil."
Gas producers have been some of the strongest performers in the rebound that kicked off in late February even though the fuel has seen just a fraction of crude's increase. The trigger for investors is that for heavily indebted drillers, even small upticks in gas prices provide hundreds of millions of additional cash to cover debt payments and stave off defaults, said Mark Hanson, an analyst at Morningstar Inc.
Shouldering debt loads that in some cases dwarf their market values, gas drillers need every dollar they can corral to stay on the good side of their lenders, he said from Chicago.
"Penny moves here and there in the price of gas are huge because they can juice another $200-million or $300-million in EBITDA," Mr. Hanson said. "That can be the difference in avoiding a covenant default. There's renewed hope for these names every time gas moves a nickel."