The Price Is Right

Story Highlights:

• Oil prices have fallen significantly over the past month, causing many to wonder if energy's long run may be over.
• Prices remain high, and the recent sell-off isn't evidence of a further decline ahead.
• If oil does decline further, energy stocks won't necessarily follow.

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Oil prices have a knack for scaring folks. Think back just a month ago: Near panic ensued as prices broke records on a frighteningly regular basis—up over $145 per barrel at one point. "Staycations" were all the rage, car companies changed their lineups, fears of rampant inflation flourished, and more than a few doomsday scenarios were spawned. Fast forward to today: Oil has fallen over $30 per barrel, trading around $115 at the moment. Now folks are worried about falling prices. Are they the canary in the coal mine for a weaker global economy? Do they spell the end of the long run of outperformance for energy stocks?

Let's take a step back. First of all, markets move on a forward-looking basis. The impact, whatever it may be, of the recent fall in oil prices is already reflected in prices. The question is where they're headed in the future. Anyway, who was predicting $115 oil back in the panicky days of July? Few we can recall. Not surprising, since (breaking news) oil prices are volatile and unpredictable, especially in the short run. In other words, that prices have fallen over 20% tells nothing about where they'll be in September and beyond. So if you're convinced the last few weeks mean a continued freefall in prices, don't bet on it. A more telling sign for future energy prices is the strength of demand, which remains underappreciated in our view. As developing economies bring millions of folks into the middle class (all of whom will be wanting cars and spurring new construction for homes and shopping centers), the fact is oil demand will do little but rise in the years ahead.

Nevertheless, recent price declines have many extrapolating the data into a sell-off for energy stocks. Energy's had quite a run, outperforming the broader markets for years. But it's taken it on the chin throughout the recent drop—declining roughly in line with oil prices. Intuitively, this makes sense. After all, if oil companies make record profits on record prices for oil, it stands to reason they would suffer amid falling prices.

But taking a longer view than a few weeks, we'd advise caution. During the current expansion, oil prices have had a few sharp drops. Sometimes energy shares have fallen with them and sometimes not. The biggest drop (on a percentage basis) happened when oil prices hit a scandalous $80 in August of 2006 only to fall to $55 in January of 2007. But during the same period, oil stocks did just fine, basically treading water. There were also times when oil prices and energy shares sold off together, like they have this time. What about over the long haul? Still murky. Over time, the correlation between oil prices and oil stocks is only about 0.37. Higher than for stocks overall, but not exactly joined at the hip, either. Why might this be?

Simply, earnings and commodity prices are not the same. There are many factors for earnings. A few include production growth (a result of increased investment during the good times), cost cutting (during the bad times) and contract pipelines (as many drilling companies have locked in contract prices far into the future). Share prices can also be bolstered by stock repurchases and M&A activity. We'd wager more than a few of today's cash-rich energy companies are eyeing potential takeover targets whose stock prices have recently weakened.

If you're worried about falling prices and the implications for energy stocks, perhaps the more important point is to see the past few weeks in their proper context. Oil prices, despite the recent gyrations, are up nearly 20% on the year, and up 63% from a year ago. Energy prices may be up or down in the short run, but unless you believe they'll be down over the long haul—unlikely in our view—the price is still right for oil stocks.