Why Are Oil Stocks So Undervalued Right Now?

Lately, the oil bulls just can't seem to catch a proper break. Just when oil prices were consolidating after OPEC+ reached an agreement on production quotas, the markets have gone into free-fall once again. Oil prices are on pace for their worst trading week in more than nine months after the latest EIA data showed that U.S. crude inventories unexpectedly rose sharply last week, with crude inventories showing a +3.6M barrels build vs. -3.1M consensus, and -4.1M the previous week. But it's not just rising U.S. stockpiles that have thrown the markets off-kilter. News that the COVID-19 Delta variant is running riot in China does not augur well for the global markets.

West Texas Intermediate oil slipped as low as $67.85 a barrel on Wednesday, about 8% lower compared to Friday's close.

As usual, as energy prices go, energy stocks usually follow.

The broad energy sector benchmark, Energy Select Sector SPDR ETF (NYSEARCA:XLE), is down a relatively tame 2.4% over the past three sessions.

However, other energy funds are not so lucky, with the United States Oil ETF(NYSEARCA:USO) down 7.0% over the past three sessions while the VanEck Vectors Oil Services ETF (NYSEARCA:OIH) and ALPS Alerian MLP ETF (NYSEARCA:AMLP) have slipped 6.0% and 3.6%, respectively.

Worth noting: USO is different from OIH, XLE, and AMLP because it invests in oil futures contracts rather than in stocks.

That said, the surprising thing is that despite the latest selloff, energy stocks are still among the top performers this year.

XLE is up 28.0% in the year-to-date, outpacing the S&P 500 Index by more than 10 percentage points.

USO has surged 43.0% YTD; OIH is up 16.3%, while AMLP has gained 27.4% over the timeframe.

Yet, many investors will be surprised to discover that despite these market-trouncing gains, oil stocks have actually been lagging oil prices by a significant margin this year.

Cheap oil stocks

The price of WTI Crude oil has climbed about 45% in the year-to-date as many economies reopened amid increasing vaccination rates and trillions of dollars of fiscal stimulus flowed into the markets. 

According to Citigroup analysts, gains by oil stocks should be stronger than that given historical trends. 

Mind you, oil prices themselves are still very cheap when compared to another leading commodity--gold, as we pointed out here.

In a recent research note, Morgan Stanley's Martijn Rats and Amy Sergeant have said that although the oil-gold ratio has historically been a poor indicator of future oil prices, it can still be of interest to investors seeking guidance on the direction of oil prices.

So, how's that trending?

We can go back and see the number of barrels of oil a single ounce of gold could buy at any point in time i.e., barrels per ounce.

The long-term average Gold-Oil ratio has been that one ounce of gold would buy 16.53 barrels of oil. Any time an ounce of gold would buy more than 16.53 barrels of oil meant that either oil was cheap or gold was expensive. Conversely, oil has been regarded as being expensive or gold cheap whenever an ounce of gold would buy less than 16.53 barrels. Knowing this can help investors determine whether they should be buying more oil and selling their gold, or vice-versa.

Going by this,  oil prices would need to climb to ~$110/bbl for the gold-oil ratio to return to its historic median. Suddenly, Bank of America's recent prediction that oil prices could hit $100 per barrel in 2022 does not appear so far-fetched.

And, that also means that oil stocks could have an even bigger upside than current oil prices suggest.

Lower forever?

Either that, or we need to recalibrate our expectations regarding oil prices.

As Shell (NYSE:RDS.A) CEO Ben van Buerden cautioned a few years ago, the oil industry could have entered an era of 'Lower Forever' mostly due to the green energy transition, climate mandates, and increasingly hostile government policies.

However, these are long-term headwinds with time horizons of 10,15, or maybe 20 years.

With key renewable sectors such as EVs and solar facing formidable challenges themselves, the oil bulls still have the upper hand.