Curses, Oiled Again

3/14/2011


Investors are getting a bad case of déjà vu when it comes to oil prices.

Flash back a little over three years, when oil prices were on their way up, reaching $145 a barrel by July 2008. Does the latest advance in oil prices, sparked by uncertainties in the Middle East as well as improving global economies, foreshadow a similar move to the $140s this year? Is $200 oil possible? Will a U.S. economy that is recovering but still in need of governmental "training wheels" (quantitative easing, for example) falter badly in the face of higher oil prices?

Obviously, these questions weigh on investor sentiment. The percentage of bullish advisers has in the last three weeks fallen to its lowest level since November. To be sure, the percentage of bulls is still up sharply from sub-30% levels seen last August. Thus, the sentiment glass remains half-empty or half-full, depending on your position.

The bulls argue that this market has absorbed a number of body blows without crumbling to the canvas. Conventional wisdom says higher oil prices; regime changes in Egypt, Tunisia, and possibly Libya; rising inflation in emerging markets; and record-high food prices should have crippled the stock market. Yet the Dow Industrials are just 2% off the Feb. 18 high. Bullish advisers argue continued strength in corporate profits should trump volatile oil prices when it comes to stock movements.

Unfortunately, investors will have to wait until the release of March-quarter earnings for more evidence of the continued strength in corporate profits. Most quarterly reports won't start rolling in until mid-April. However, the Middle East and oil prices will continue to affect stock prices in the interim.

Bearish advisers believe it is only a matter of time before stocks fall under the weight of higher oil prices. These advisers point to the continued slump in U.S. same-store sales at retail giant Wal-Mart Stores ($52; WMT) as a proxy for the spending woes of "the masses." Substantially higher oil prices will only exacerbate the problem for a huge chunk of the population.

And with the employment picture experiencing a number of cross-currents — seemingly higher private-sector hiring offset by likely declines in public-sector jobs — and housing markets still struggling, bears argue consumer spending will not rise in the short run. Weaker consumer spending and higher material costs for petroleum-dependent sectors will result in disappointing corporate profits, say the bears.

While acknowledging that the market may move lower in the short term in line with a typical correction, the Forecasts continues to see the market's primary trend as bullish. History has illustrated the danger of overhauling a portfolio's holdings and asset allocation as a result of a bet on oil prices. Indeed, investors should remember that while oil prices reached $145 per barrel in July 2008, they had dipped below $40 just six months later.

For investors wanting oil exposure, Dow Theory Forecasts favors Exxon Mobil ($85; XOM) and Hess ($84; HES).

Exxon's 2011 consensus earnings estimate has jumped 10% in the last 60 days and now stands at $7.17 per share, up 15% from 2010 earnings. The stock is trading at less than 12 times the 2011 estimate, a discount to the sector. Higher profits should allow for another dividend increase with the June payment, probably in the 5% to 8% range.

Hess shares have advanced 9% so far this year and look poised to tack on additional gains should oil prices plateau or move higher. Earnings estimates, too, are rising. The consensus 2011 estimate is now at $6.45 per share, up 9% in the last 60 days and 25% above 2010 earnings. Exxon Mobil is a Focus List Buy and Long-Term Buy. Hess is rated Buy and Long-Term Buy.


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