Oil Headed To $25? Time To Accumulate For The Long-Term

Before discussing the current CW on oil prices, I’d like to direct readers to a previous commentary I posted back in July 2007:

Goldilocks’ Housing Porridge Still Too Cold

Please keep in mind back then, 10-year interest rates were hovering around 5% and the prevailing theme of the financial media asserted the most likely outcome of the housing bust would be a “soft landing.”   As I said back then, to think that the rest of the world would decouple from the US was a bit of a stretch but to believe that the US could decouple from its own housing market seemed unbelievable.  Today in hindsight, it’s easy to say that a protracted pain period obviously awaited.

I don’t bring this up to point out how correct I was (ok, maybe that’s a small motivation) but rather, to make a broader point about markets.  Many of the analysts who regularly discuss markets and the economy on TV and print live in a bubble-like environment.  They are so busy with reading, research, meetings, doing TV appearances, ass-kissing (c’mon of course they do), etc. that it’s easy to see how they become detached from real-world conditions.  Frankly, one can find an opinion backed by a wide array of model projections, backtested data, etc. but the one quality lacking is simple common sense. While it may seem quaint, a little dose of common sense can save investors a lot of money.

Oil may be headed to $25 but will it stay there or go lower?  If it does, one must ask what conditions would exist that would allow oil to stay there?  I try to do this with all my investments.  If I think a stock is worth $x, then I try to visualize what conditions would exist to allow it to get there.  Consider the opposite — if you think a stock is worth $x, try to visualize it dropping 50% in value and what conditions might cause it to do so.  So I visualize a few different scenarios, do my best to put very subjective probabilities on each case and use the combined EV to help my investment decision.


So ponder the question, if oil falls to $25/bbl, how does that happen?  But what of the rest of the economy?  Can you visualize refilled malls, overflow Starbucks, booming construction, a revitalized Wall Street with oil prices so low?  Will the automakers rebound and head back to early-decade sales levels and if so, why does the price of oil stay low?  In other words, were oil prices unjustifiably too high due to a speculative bubble or because the global economy came to a screeching halt almost overnight?

Readers know where I stand on this question.  I saw a Barrons ad that congratulated itself for calling the oil “bubble” right.  Like a broken clock, they called it right but for the wrong reasons.  It took nothing less than a Depression-like global financial crisis to humble the energy bull, not the deflation of a speculative mania.  After all, commodities are hardly alone in falling in price; every other asset save Treasurys and gold has suffered as much.

When the global economy recovers, energy will come roaring back because quite simply, it takes a lot of energy to do and make stuff.  What stuff?  Well, pretty much everything requires energy.  How do you build an American 21st century energy grid without energy?  How do you bring hundreds of millions of rural Chinese out of subsistence living without energy?  How will you solve the water and agriculture issues without energy? You can’t even build alternative energy without massive supplies of “old” energy.  But the current low prices guarantee that when the recovery happens, less energy will be available.

When energy prices recover, who knows?  It could take years or it could bounce back next summer.  As such, I have been transitioning into solid dividend-payers that can survive even the worst-case scenario.  Can Talisman Energy (TLM) survive 2 years of $30 oil and $5 natural gas?  I don’t know so I swapped TLM for BP.  I think Chesapeake Energy (CHK) can survive 2 years of $5 nat gas but swapping out of the common into the preferred made a lot of sense as I’ll get paid 8-9% indefinitely unless a) they go under or b) they rise above $44 in a few years.  The preferreds are cumulative so even if CHK suspends all dividends, the preferred dividends will accrue until such time the company resumes payment.  Their huge asset base provides a solid floor in the scenario where they go under as someone would buy them out before then.

Speaking of Chesapeake, like I said previously, CEO Aubrey McClendon has cracked the code on addressing market concerns about his company. After witnessing the market vomit his company’s shares after they filed for more possible dilution, McClendon took most of it back.  He also accelerated the balance sheet repair and cut capex even more from just a month ago.  CHK now projects being free cash flow positive by Q4 2008, which I’ll have to see to believe.  The company is also projecting at least $2B FCF for 2009 and 2010.  The market approves, pushing shares up 30% today.  I would like to see them suspend the dividend as well (easy for me to say) but if they follow through on their newly conservative plan, Chesapeake Energy looks like a no-brainer to me.

And for readers who don’t normally invest in energy stocks (or stocks altogether), maybe consider buying a blue-chip dividend paying energy stock as a hedge against energy prices.  Enjoy the low gas prices while they last (road trip, anyone?).  Once gas prices start rising again, at least your portfolio will benefit while your wallet suffers.

More on this topic (What's this?)
Energy Stocks Will Roar Back - But Not Soon
Mexican Oil Production, Exports Continue Down
Read more on Oil Prices, U.S. Housing Market at Wikinvest

One Response to “Oil Headed To $25? Time To Accumulate For The Long-Term”

  1. Recommended Reading - Dec 12,2008 | Old School Value Says:

    [...] Oil at $25? Time to Accumulate for the Long Term presented by The Enlightened American [...]

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