<THE DRIP PORTFOLIO>
Oil - Past and Futures
The role of the commodity markets
by Brian Graney ([email protected])
ALEXANDRIA, VA (Nov. 19, 1998) -- Since we've already broken two unspoken rules in Fooldom by discussing politics and economics this week, we may as well try for our third strike by using today's column to look at another taboo subject around here: futures.
Do not adjust your screens. This is not some ill-conceived, derivatives-focused offshoot of the Fool's newly-christened Rule Breaker portfolio. This is still the same old Drip Port you know and love. Jeff and I haven't lost our minds, at least not yet.
We much prefer the stock market to the futures market. But, for better or for worse, the oil and gas industry is impacted greatly by the futures market. So, we can't just gloss over its existence like we are apt to do with the markets for stock index options, interest rate swaps, and other addictive but dangerous forms of financial narcotics.
Let's face it -- producing oil is a commodity business. From the market's point of view, painting oil barrels red with a yellow scallop shell logo instead of blue with a red winged horse does not change the fact that the stuff inside those barrels is essentially a mixture of different types of hydrocarbons which, once refined, can be used as fuel. This places oil in the same basic-product realm as other commodities, such as silver, pork bellies, and white Gap pocket tee-shirts.
As a result, oil prices fluctuate -- a fact which ends up being reflected in the cash flows and share prices of the companies in the oil and gas industry. The Fool's Alex Schay explained why this is true much better than I ever could in a Fool Plate Special earlier this year.
However, all crude oil is not alike. Crude oil from different parts of the world can vary greatly in terms of color, sulfur content, and chemical makeup, depending on the geology of the area from which it was drawn. (For a nifty overview of crude oil's variations, click here)
As a result, all kinds of crude oils and refined products are traded on the world's commodity markets and given an assortment of different values. There are spot prices, futures prices, 15-day forward prices, Vincent Prices... okay, I made that last one up. You get the picture. But for the scope of our study, we only need to be familiar with one or two of the most basic pricing mechanisms.
When we talk about "oil prices" in this column, we will be referring to the going rate for the 1,000 barrel oil futures contracts which are traded on the New York Mercantile Exchange, or Nymex. Often, commentators will alternatively refer to Brent crude oil futures prices, which are traded in London on the International Petroleum Exchange (IPE). Two other major global oil pricing benchmarks out there are Dubai Fateh and Tapis prices, just in case you feel the need to impress your friends with your knowledge of oil trivia at a cocktail party this weekend.
Since Jeff recently shot-down my idea of renaming our daily portfolio reports The Daily Global Oil Spot and Futures Market Financial Report, we will avoid tracking the day-to-day movements of the various oil-related commodity markets. But oil prices will play an important role in our study when it comes time to separate the very best oil companies from all the rest.
As we have discussed recently, U.S. oil and gas producers can do very little to change the international political and economic environments confronting them. All they can hope to do is adjust their businesses appropriately to remain profitable under adverse conditions, especially when the price of oil drops.
This brings us to a key business attribute we will be looking for during the course of our study:
Ideally, we want to invest in the company that can outperform its peers when the price of oil is historically high as well as when the price of oil is historically low.
With our 20-year (or longer) holding period, this requirement is a no-brainer. Over the life of our investment, oil prices will fluctuate up and down, often swinging with such magnitude as to make Tarzan himself jealous. Before we allocate our investment dollars, we must be absolutely convinced that our chosen company will do well when times are good and when times are tough.
Right now, times are tough in the oil business. The price of oil has fallen about 30% over the past year to roughly $13 a barrel. Demand has contracted as financial crises have spread from Asia to Russia to South America. Supply was boosted by 10% at precisely the wrong time by OPEC last year, fueling a worldwide glut. Fears of a global deflation, a rekindling of tensions in the Middle East, and a rapidly decreasing oil reserve base are rampant. Have I left out anything?
Given the dark clouds currently hanging over the oil and gas companies, now may be the perfect time for long-term investors like us to investigate the industry. If we can identify a superior company with an attractive valuation that is performing well right now, it should perform even better when the storm clouds dissipate to yield a brighter sky.
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