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How to Spot the Bottom in Oil Prices

By now, you have probably seen many prognostications about the economics of oil and how low prices will go before they hit bottom. These analyses are often self-reinforcing — authors with the most at stake tend to be the most optimistic. In the investment business, we call that “talking your book.” Oil company executives, for example, have been quick to predict a recovery, even as they slash their capital budgets.

I’m in Texas, and I have an oil well (or at least part of an oil well or two), so clearly I want to believe that oil prices will rise. But history suggests otherwise. At its high last summer a barrel of West Texas Intermediate crude sold for $108 a barrel. Today, it’s at about $50, a decline of 54 percent in about seven months.

Sell-offs of this magnitude don’t often lead to a prompt recovery. What makes this drop in oil prices a bit unusual is that it isn’t the result of one factor, but of several coming together. The first, obviously, is surge in U.S. production driven by high-tech advances that combine hydraulic fracturing and horizontal drilling. The U.S. has increased its oil output steadily since 2008, and even with the recent downturn in prices, production this year is expected to be the highest since 1972.

At the same time, global demand has slowed. Prior to the global recession in 2008, emerging markets, particularly in Asia, had been steadily increasing their demand for oil and other fuels. That growth has stalled, and the demand for oil has pulled back. The slackening demand, combined with skyrocketing U.S. production, has created a catalyst for change in the global oil markets. OPEC has refused to cut production, choosing to maintain market share rather than support prices. One other variable that could alter the current situation would be new regulations from the U.S. Environmental Protection Agency.

Now let’s look at what’s happening with oil stocks in relation to crude prices. We’re seeing a growing divergence between the price of large, diversified players and aggressively leveraged exploration and production (E&P) firms. Let’s use the biggest U.S. diversified company, Exxon Mobil (NYSE: XOM) as an example. Exxon’s shares are trading within 12% of their all-time high. More leveraged E&P companies such as Goodrich Petroleum (NYSE: GDP), on the other hand, have been battered by falling oil prices. Goodrich’s shares have plunged more than 85 percent since last summer. Investors have seen their market value evaporate as crude prices fell.

At some point, companies with more stable stock values are going to take advantage of the discount that the market is putting on E&P companies like Goodrich. Let’s be clear: I’m not implying that Exxon is going to buy Goodrich. If Exxon is going shopping, it’s probably looking for a bigger prize. (It’s been rumored for months to be eyeing BP, whose shares have been hammered by oil prices, problems in Russia and ongoing litigation from the Deepwater Horizon disaster.)

But we may be reaching the point in the market where larger, more stable companies are going to start buying smaller, more leveraged rivals because they represent a chance to acquire assets at an attractive price. We’re not there yet. Most forecasts are predicting less deal activity in the first half of this year than we saw at the beginning of 2014. But deal activity can be a bellwether for price. The divergence in the share prices between buyers and targets typically is at its widest when the market nears bottom. In other words, oil prices are likely to stop falling about the time we see a dramatic pick-up in mergers.

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