The end of the oil stock rally

By Jim Jubak

Don't expect a break in the price of oil until November. There are some nasty shocks on the supply side just waiting in the wings, and any break in prices in the meantime is likely to be short-lived.

But that doesn't mean the price of oil stocks will continue to rise until then. We're nearing a temporary top that will culminate in a correction that takes down stock prices 10% or more.

We're likely to see that correction anytime between now and September. If you're late to the oil stock rally, you're better off waiting for that correction than rushing to place your bets in the sector now.

As always, it's all about supply and demand -- for both oil and oil stocks. And the balance of supply and demand for oil versus oil stocks looks very different in the short run. That's why we're likely to see a temporary fall in the price of oil stocks, even as the price of oil continues to climb.

Let's start with the short-term supply-demand balance for oil.

The good news on demand is that U.S. drivers traveled an estimated 11 billion fewer miles in March 2008 than in the same month a year ago. That's a drop of 4.3% year to year. In the first three months of 2008, U.S. drivers reduced their mileage 2.3%.

These drops, in response to higher gas prices, are a reason the U.S. Energy Information Agency projects the nation's petroleum consumption will drop by 330,000 barrels a day in 2008. (Increased use of ethanol is the other part of the picture.) That amounts to a drop of about 1.6%.

The bad news on demand is that the rest of the world is more than making up for any drop in consumption in the United States. This year's global demand is expected to grow by 1.2 million barrels a day, or about 1.4%, despite the decline in U.S. consumption. The biggest increase in global consumption comes from China, with a projected increase in 2008 of 400,000 barrels a day, but consumption is also expected to show major upticks in Russia, the Middle East and India.

Why have higher prices for oil and gasoline damped consumption in developed economies, such as the United States, but not in China, Russia, India and the Middle East? One word: subsidies. Thanks to government subsidies, consumers in these countries are shielded from the full increases in the price of gasoline. Any wonder that gasoline consumption is up 4.5% in Iran, where gas costs 42 cents a gallon, even as world oil prices soar?

Subsidies get ever more expensive as the price of a barrel of oil climbs. Recently, a few countries have thrown in the towel. Indonesia announced May 22 that it would "soon" curtail subsidies and let prices climb by up to 28%. Taiwan will end subsidies on oil and gasoline as of June 1. Malaysia will, for the moment, keep its subsidy program intact but will cut the level of subsidies by about 15%.

Higher oil prices won't have a chance to cut global consumption, though, until China and India reduce or eliminate their subsidies. In both cases, domestic politics trump any budgetary pressure. China is unlikely to reduce subsidies and risk domestic protest before the Beijing Olympics in August, and India's ruling Congress Party, facing a tough election in 2009, isn't likely to risk its political future by ending subsidies before that vote.

Oil production won't save us

Don't expect an increase in global supply to bail out the failure to cut consumption. On the supply side, the recent news has been downright scary.

In Mexico, oil production is falling far more rapidly than anyone had projected. Average daily production fell in April to 2.77 million barrels a day from 2.85 million in March and 3.18 million in April 2007, according to state oil company Pemex. Efforts to allow Pemex to recruit foreign capital and expertise by signing pay-for-performance contracts with foreign companies have run into fierce opposition in Mexico's Congress. A national debate on the issues, which began May 13, is scheduled to last for 71 days, and there's no guarantee the pay-for-performance legislation will pass after the debate ends.

In Russia, the minister for natural resources has warned that production, which declined in the first quarter of the year, could fall for all of 2008. The Moscow government recently cut oil industry taxes by $4 billion annually to increase investment in the sector. That's not nearly enough, even with a second $20 billion cut now under discussion, and any increase in investment in production now will take years to turn into increased oil flows.

The bad news on the supply side is likely to reach a peak in November when the International Energy Agency, the energy arm of the developed economies that make up the Organisation for Economic Co-operation and Development, is set to release its most detailed report ever on the state of the world's oil reserves. The report will likely paint a bleak picture of declining production from mature reserves and project that massive additional investment can slow but not reverse the decline.

There's enough near-term bad news in all these developments to keep oil prices inching upward from the recent $135-a-barrel level. Any correction in oil prices -- and remember, corrections are a regular and normal part of all rallies -- is likely to follow the fall peak in bad news.

Stocks altogether different

The supply-demand picture is very different for oil stocks than it is for oil itself. Here we're starting to run out of the most critical component of supply: skeptical investors who don't own any oil stocks. Stocks go up in price as new investors become convinced that they have to own these shares.

In the early stages, a sector rally depends on a supply of value buyers who are convinced the true fundamental value of the stocks in the sector isn't expressed in current prices.

In the middle stage, stock prices depend on a supply of new growth buyers who come to believe the arguments of value investors that the group is undervalued and who see evidence of earnings growth.

And in the final stages, the rally in the sector depends on momentum investors who, not having been convinced by the value or growth arguments, now decide to buy because the appreciation in stock prices in the sector becomes too tempting to resist.

Continued: Don't buy overpriced oil stocks

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