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Aug. 10, 2017, 2:46 p.m. EDT

Stop believing these 5 oil myths and start buying energy stocks

Skittish energy investors are latching on to the negatives and ignoring the bigger picture

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By Michael Brush, MarketWatch


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The Permian Basin is a production marvel.

Energy investors continue to be more skittish than a cat on the loose at the Westminster Dog Show.

Permian Basin energy companies reported reasonably good results in early August — not surprising since this oil patch stretching through West Texas and New Mexico is one of the best places in the world to produce crude.

But there were negatives as well, like some well delays, reports of higher costs, and a rising percentage of less-profitable natural gas in the production mix, from Pioneer Natural Resources /zigman2/quotes/206736173/composite PXD -0.76%   and Parsley Energy /zigman2/quotes/200138201/composite PE -0.44% , among others.

Skittish energy investors latched on to the negatives and sold the group, even though the Permian is no less an energy production marvel than it was in July. “It’s just crazy the way these stocks are moving around,” says Mike Breard, a seasoned energy analyst at Hodges Capital Management. “Companies can say six things in a press release, and investors will pick out the one negative thing.”

That is bad enough, but energy investors are making another mistake. Many are embracing myths that implant the deadly trio of fear, uncertainty and doubt in their minds. This naturally increases skittishness.

Pity them for a moment. After all, energy is the worst place to be so far this year. While their investment colleagues are enjoying great gains in Netflix /zigman2/quotes/202353025/composite NFLX +2.07% , Amazon.com /zigman2/quotes/210331248/composite AMZN +2.49% , Alphabet /zigman2/quotes/205453964/composite GOOG +1.17%   /zigman2/quotes/202490156/composite GOOGL +1.14% , Facebook /zigman2/quotes/205064656/composite FB +2.12%  or even the S&P 500 /zigman2/quotes/210599714/realtime SPX +1.60% , the S&P energy index is down by over 13%.

But also look on the bright side. This creates some wicked volatility in the energy space that allows you to pick up some of these names either as swing trades or multiyear plays on rising oil prices.

Barring a global recession, oil prices are headed up over the next few years as supply shrinks due to project cutbacks and natural production declines, but demand continues to march higher. Raymond James analyst John Freeman predicts an average oil price of $65 a barrel in 2018. Will Riley, who helps manage the Guinness Atkinson Global Energy Fund /zigman2/quotes/208666626/realtime GAGEX -0.80% , thinks crude will hit $60-$70 by the end of the decade.

Investors don’t really want to believe it, because they embrace the following myths about crude prices. But they will come around as these myths fade — and so will energy stocks.

Myth No. 1: U.S. inventories are ‘too high’

Energy investors remain hyperfocused on U.S. inventories. This is dumb, because they only makes up about a quarter of global inventories. But investors also focus on the wrong baseline — 10-year historical averages of around 350 million to 390 million barrels. This makes little sense since U.S. production has risen 80% in the past six years. So naturally the U.S. energy distribution system needs more tanks and pipes to move crude to market.

Click to Play

How energy prices are dependent on supply performance

Daniel Yergin says the future of energy prices depends on global economic factors like when inventories will get absorbed. He spoke at the WSJ CFO Network annual meeting.

This suggests the natural steady-state inventory level should be more like 465 million barrels (excluding the strategic petroleum reserve), maintains Freeman at Raymond James. That’s not far below recent inventory of around 475 million barrels. This narrowing of the gap hasn’t improved sentiment on crude that much. But it will once this myth explodes.

Reports on global inventories due out soon might help as well if they show declines, which I expect.

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