E 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.

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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 4 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. 4 years ago Member's comment

Agreed!

Roger Harris 4 years ago Member's comment

This was a great read, thanks.

Joe Economy 4 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 4 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 4 years ago Member's comment

Interesting ideas.