There is something very interesting developing in the oil markets right now.
It's not front page news yet, but it is something that you'll want to keep an eye on – especially if you want to make money with oil stocks.
It revolves around what's called "the spread." In this case it's the difference in price between West Texas Intermediate (WTI) and Brent.
Once again, the price of these two oil benchmarks is moving in opposite directions. The price of crude in New York is going south, while the price in London is heading north.
In fact, as of open this morning, the spread between the two now stands at 15.6% of the WTI price and continues to widen. In the last week, this spread has almost doubled.
This move is helping to create what I call a valuation disconnect.
The good news is that this growing "spread" is going to make us even more money…
The Problem with the "Conventional Wisdom"
Let me explain what I mean by that…
In the past, we used to look at this spread as a yardstick for estimating the effect of the differential on actual changes in crude oil pricing. In this case, the "paper" barrels – representing the one-month out, or near-month, commitments to purchase crude – tend to drive up (or down) the effective price of the "wet" barrels, or the actual oil sold.
Now on any given day, there are far more paper barrels than wet barrels traded, with the excess futures commitments canceled out prior to the actual delivery of oil.
For some time, these futures have been leading the market price for oil, causing occasional criticisms that price volatility is more a result of the paper trade than the demand for the oil itself.
This has been a recurring theme when it comes to the commentary on oil price trends.
Movements in futures do tend to pull along the underlying market price. This connection still holds in large part, but it is the second part of the assumption that is now undergoing some interesting change.
The "conventional wisdom" would tell you that the futures price-market price dynamic should impact the profitability of individual oil-related companies.
Now this appears obvious, at least on its face…
If the profit margin on the actual oil shrinks, shouldn't there be a similar move in the shares of the oil companies?
Well, that's not true anymore – at least not for all companies.
In what is shaping up to be a significant revision in how investors should look at oil stocks, there is a disconnect now developing between the underlying price of the raw material and the value of selected oil stocks.
This valuation disconnect has developed because there are now several other market factors involved besides the price of the raw material itself.
A New Normal for Oil Stocks
To be sure, an absolute collapse or an accelerated spike in oil prices would have a short-term impact across the board. What I am referring to here is WTI and Brent prices losing or gaining 30% or more of value over a narrow period.
Such a highly unusual and compressed volatility cycle is what statisticians refer to as kurtosis.
This simply means that most of the change takes place in a very short period of time, rather than over broader periods where the market can compensate for changes in the trend. These are very rare events that render the model used to determine proper futures pricing inoperable. That merely adds to the volatility.
Of course, I have investment strategies designed to deal with these highly unusual events. But what occurs most of the time is something else quite different.
Here we are experiencing the emergence of a different series of relationships.
And unless a price point is determined by a sudden collapse in demand (something that is not going to happen anytime even remotely soon), there is a threshold of oil demand the market cannot cross without triggering significant supply-side pricing inflation (via localized constriction in availability).
This "new normal" tells us that prices may advance or decline in a narrower range more frequently. But this hardly has the same effect across the board.
In other words, some companies will fare better than others…
And there are three ways to identify the winners. Here's what you need to look for:
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.