Why Oil Can’t Provide ‘Deep Value’

With oil trading at the lowest prices in a generation, an increasing number of commentators are beginning to describe the commodity as one that offers ‘deep value’.

While oil is certainly trading at a deep discount to its long term average price, and may very well regress back towards this average with higher prices, there is simply no way that it can accurately be described as offering deep value in the traditional sense of this phrase. Let’s take a look at what happens when we try to apply the conceptual framework of deep value to oil and other natural resources.

Understanding Deep Value

Deep value is a methodology of buying something for less than its actual, intrinsic worth. When applied to shares in a company’s stock, this ultimately means that if the company were to be liquidated its net asset value and the proceeds divided among its shareholders, they would each receive more than the current share price. A pricing inefficiency has caused shares on the open market to take on a value that is lower than the intrinsic value of the company’s stock.

When we try and apply this concept to crude oil, we immediately run into insurmountable problems. Oil does not appear to have an intrinsic value. Its value at any given time is determined entirely by the open market, which is to say the balance of supply and demand.

This can be hard to appreciate because all developed and developing economies need oil, and lots of it. In that sense oil certainly seems like it should be more universally valuable than, say, the shares of a small pharmaceuticals firm manufacturing a handful of specialist drugs.

The crucial difference here is that a stock is actually just a ‘wrapper’ for a diverse bundle of both tangible and strictly notional assets and liabilities: prospective dividend yields, earnings, liabilities, real estate holdings, trademarks, patents, goodwill. . . Some of these assets may have a known liquidation value that can be substantially greater than the price at which the ‘wrapper’ can be acquired on the open market. This temporary dislocation between the market price and reality is what value investors are looking for.

The Cost of Carry

There’s only one other variable that’s wrapped up in the price of oil besides what you can sell it for, and it is the price that you will pay to transport and store it. If oil were a stock, then cost of carry would be added to the balance sheet as a liability.

A barrel of oil, unlike a share, has a cost of carry. From the moment it’s extracted from the earth, someone has to pay to store it. While you’re unlikely to be planning on stacking drums of Brent crude in your garage under the guise of a deep value investment, any ETFs you might purchase such as OIL or USO probably track the market using futures contracts, which are supposed to reflect the cost of shipment and storage. Supply gluts can impact on these costs, and market volatility can impact on the accuracy with which they’re priced in.

Energy producers hope that the expenses they incur in storing oil will be reflected in the futures price, but as settlement approaches, contango scenarios can resolve with a fall in the spot value just as easily as a rise in the futures value. If derivatives market prices deviate from an accurate reflection of carry costs, your oil might turn out to be worth less than you think.

A Margin of Safety

A further characteristic of deep value investing is the ‘margin of safety’. Because it is very difficult, even in the most favorable and transparent of circumstances, to accurately value a company, value investors assume a worst-case scenario in their calculations, with conservative valuations providing a safety net for their purchases. There’s plenty of room for error without getting your fingers burned.

It’s much easier to place a definite value on oil: whatever price buyers are currently willing to pay.

What’s more, crude oil’s current, heavily eroded price magnifies normal volatility in terms of the percentage loss or gain to an investment, working against. Normal fluctuations in the price of oil result in a daily range of around $2. When it was trading at $107 per barrel in June of 2014 this was a mere 1.8% change in its value; at $28 per barrel it equates to a 7.1% loss. Buy oil just 10 days before the market bottoms out, and with no volatility outside of the normal range your position may undergo a devastating 71% drawdown, which is the kind of adverse excursion that will cause most investors to balk.

Cheapness does not equate with a discount from true value, and extremely low prices in a volatile market are often the opposite of a margin of safety.

Unlocking Value

It’s quite common for deep value practitioners to time their acquisitions around a catalyst that they hope will unlock value within a firm. For example, if a pharmaceuticals company has invested heavily in developing and conduct trials for a new drug, when the product comes to market then this event should unlock value within the company.

While there are obviously events that could trigger a turnaround in oil prices, none of these could really be said to unlock value. Any adverse news in the current environment will likely drive oil prices lower, but for deep value investors the very worst kind of catastrophe, the liquidation or acquisition of a company, can be the catalyst that unlocks value.

A Different Type of Value

So if oil can’t provide a deep value investment, what sort of value can it offer?

The best term to describe the potential value to be found in crude oil is probably ‘relative value’. This ‘relativity’ involves time – oil’s higher prices in the past and anticipated higher prices in the future – and it is therefore speculative in nature.

The difference between buying oil at temptingly low prices and deep value investing is very similar to the difference between pure and statistical arbitrage. Practitioners of the latter buy when they think something is cheap relative to its expected price at a future time; pure arbitrageurs buy something when they know that it is cheaper than the sale price they can realize right now.

There are plenty of perfectly valid reasons why both funds and independent investors may be looking to begin accumulating a long position in oil now or in the near future.

If you believe that markets are efficient and follow a random walk, then a simple philosophy of reversion to the mean can justify buying at the current low prices. If you’re an analyst with a global-macro bent and perceive a shift in the global political and economic landscape, then by all means recommend oil as a buy. And if you’re a trend-following CTA and prices begin to head higher then, sooner or later, it certainly makes sense for you to be buying oil.

But whatever you do, please don’t call it ‘deep value’ investing.

Disclosure: I currently have no positions in USO, OIL, or any energy stock or derivative.

Disclaimer: The information in this article represents my own opinions and does not contain ...

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Rick Pell 6 years ago Member's comment

Alexander: You certainly showed me a different perspective on the so-called "value" of oil and my future in the trade of it will reflect that. Thank you sir!

Sunny L. 6 years ago Member's comment

Agreed!

Roger Harris 6 years ago Member's comment

This was a great read, thanks.

Joe Economy 6 years ago Member's comment

Its truly an incredible thing what effect the mere rumor of OPEC change in supply policy can have the the black stuff. How can one ever trust the value of something so vulnerable to the latest OPEC policy rumor? Some day perhaps there will be such a thing as an oil bank where you could store your oil and wait for the price to increase before trading it in a similar way to what the oil companies are doing by storing millions of gallons of oil in supertankers out at sea? For now, the average consumer uses oil as a source of energy and not as an investment tool, and probably sleeps better because of that!

Alexander Pearson 6 years ago Author's comment

Thanks for your comment. I don't think the concept of community oil (or fuel) banks is too outlandish; certainly the average consumer prefers and understands holding an underlying physical commodity to any kind of complicated derivative.

I'm currently researching a piece about the effect of falling oil prices on the storage companies (BKEP, NV, KMI etc), and was somewhat surprised to discover that the supply glut hasn't helped their share prices, which seems counterintuitive.

Mark Friedmann 6 years ago Member's comment

Interesting ideas.