The EIS portfolio is now substantially out of the stock market and in cash. What sort of an energy investment strategy is cash?  It’s the strategy you might want to employ when you judge that

  1. All stocks are likely to decline, taking energy stocks down with them, or

  2. Oil and/or gas have become short term overpriced and are likely to correct , or

  3. Energy stocks have run so far that they’ve become severely overpriced. 

I’ve come to judge that  #1 above - the risk of a general market crash taking down all stocks - is becoming too great to ignore. I judge #2 - overpriced energy commodities - is a realistic risk for natural gas and a possible risk for oil.  And if the commodities do decline significantly over the next 6 - 12 months along with the bulk of stocks, I think that energy equities that look cheap now would likely become even cheaper.

Here’s why I’ve reluctantly come to believe the above is true:  

Over the past few years energy stocks have seen some severe pullbacks, but only during the roughly 50% oil price retracement from $78 in August ‘06 to $49 in January ‘07 was there a sustained loss of value for energy stocks.  Other sharp corrections reversed quickly.  The past couple of weeks have been brutal for energy stocks and have seen only modest “dead-cat” bounces to assuage the pain.  

This action of energy stocks over the past two weeks is like the post-August 2006 period, suggesting that the oil price may have a good deal further to fall.  A 50% oil price retracement of the gain from $49 to $147, similar in size to the one in 2006 would bring the price to just under $100.  If you assume that the SemGroup bankruptcy artificially took oil from about $130 to $147 and that the real top was about $130, then a 50% retracement would bring the oil price to about $90. Natural gas, which actually gained more than oil in 2008 until recently faces increasing North American supplies so has less fundamental support than oil.

The recent decline in oil stocks seems unjustified on fundamentals.   While the oil price did fall over $20 from $147, which is not nothing, analysts’ earning estimates for E&P’s for example are based on conservative oil price estimates in the $80 - $100 range, well below today’s  price of over $120.   The largest drilling company, Transocean (RIG) is estimated to earn over $14 this year and $17 next, with further gains extremely visible based on long term contracts.  Does that make its $135 share price too high?  A bubble?   Clearly not.   So the substantial declines in energy stocks  seem to be anticipating further significant reductions in oil and gas prices and perhaps further weakening of the global economy, not any speculative pricing based on current fundamentals. 

If recent weeks’ energy stock losses were simply a severe correction only in energy stocks, this might well be a buying opportunity for the group.  But such is not the case.  Rather, this energy correction comes in the context of a general market decline that has been eating away at portfolio values almost continuously since August of 2007 .  The combination of dramatic losses in energy stocks, very weak recoveries by them, and the continuing slide in the general market suggests to me a deeper significance than just an ordinary correction in energy stocks.  In short, I think the market may be signaling that there is an increasing risk that economic weakness may be spreading geographically and demographically threatening much more serious losses ahead. 

Here are some of the factors that concern me about the American economy:

  1. Consumers are still spending despite being squeezed by stagnant wages, higher unemployment, higher food and energy prices, tight credit markets, increasing home foreclosures and, most important, lower home prices.   It would not be surprising if we see these factors finally result in much lower consumer spending over the next 6 - 12 months.

  2. Banks are starting to look shaky.   I read just today of the closing of two small banks.