How to Profit from This Disconnect in the Oil Markets

There is something very interesting developing in the oil markets right now.

It's not front page news yet, but it is something that you'll want to keep an eye on - especially if you want to make money with oil stocks.

It revolves around what's called "the spread." In this case it's the difference in price between West Texas Intermediate (WTI) and Brent.

Once again, the price of these two oil benchmarks is moving in opposite directions. The price of crude in New York is going south, while the price in London is heading north.

In fact, as of open this morning, the spread between the two now stands at 15.6% of the WTI price and continues to widen. In the last week, this spread has almost doubled.

This move is helping to create what I call a valuation disconnect.

The good news is that this growing "spread" is going to make us even more money...

The Problem with the "Conventional Wisdom"

Let me explain what I mean by that...

In the past, we used to look at this spread as a yardstick for estimating the effect of the differential on actual changes in crude oil pricing. In this case, the "paper" barrels - representing the one-month out, or near-month, commitments to purchase crude - tend to drive up (or down) the effective price of the "wet" barrels, or the actual oil sold.

Now on any given day, there are far more paper barrels than wet barrels traded, with the excess futures commitments canceled out prior to the actual delivery of oil.

For some time, these futures have been leading the market price for oil, causing occasional criticisms that price volatility is more a result of the paper trade than the demand for the oil itself.

This has been a recurring theme when it comes to the commentary on oil price trends.

Movements in futures do tend to pull along the underlying market price. This connection still holds in large part, but it is the second part of the assumption that is now undergoing some interesting change.

The "conventional wisdom" would tell you that the futures price-market price dynamic should impact the profitability of individual oil-related companies.

Now this appears obvious, at least on its face...

If the profit margin on the actual oil shrinks, shouldn't there be a similar move in the shares of the oil companies?

Well, that's not true anymore - at least not for all companies.

In what is shaping up to be a significant revision in how investors should look at oil stocks, there is a disconnect now developing between the underlying price of the raw material and the value of selected oil stocks.

This valuation disconnect has developed because there are now several other market factors involved besides the price of the raw material itself.

A New Normal for Oil Stocks

To be sure, an absolute collapse or an accelerated spike in oil prices would have a short-term impact across the board. What I am referring to here is WTI and Brent prices losing or gaining 30% or more of value over a narrow period.

Such a highly unusual and compressed volatility cycle is what statisticians refer to as kurtosis.

This simply means that most of the change takes place in a very short period of time, rather than over broader periods where the market can compensate for changes in the trend. These are very rare events that render the model used to determine proper futures pricing inoperable. That merely adds to the volatility.

Of course, I have investment strategies designed to deal with these highly unusual events. But what occurs most of the time is something else quite different.

Here we are experiencing the emergence of a different series of relationships.

And unless a price point is determined by a sudden collapse in demand (something that is not going to happen anytime even remotely soon), there is a threshold of oil demand the market cannot cross without triggering significant supply-side pricing inflation (via localized constriction in availability).

This "new normal" tells us that prices may advance or decline in a narrower range more frequently. But this hardly has the same effect across the board.

In other words, some companies will fare better than others...

And there are three ways to identify the winners. Here's what you need to look for:

First, you need to identify where companies fall in the upstream-midstream-downstream sequence.

Second, you need to know exactly what regions and basins the companies are active in.

And finally, you need to understand what infrastructure components and assets are essential to the companies and are under their control (or ownership).

The first consideration is why my Energy Advantage and Energy Inner Circle services target specific sectors of the upstream-midstream-downstream sequence where pricing may actually improve beyond the average performance of the oil sector.

Meanwhile, the second merely reflects what has become a major factor in today's markets, especially in the United States. That's because production, pipeline transport, and refining are not subject to the same uniform pricing pressures in different areas of the country. Some basins have less expensive production costs, storage and transit fees, and refinery operating expenses than others.

However, it is the third consideration that is contributing the most to this new disconnect.

Here's why.

Moving product from the field to the end user involves a number of pricing points. If the transfer cost at each of these points requires arms-length contracts (those between distinct business entities), the overall profitability for the entire sequence will decline.

What is emerging, especially in the application of master limited partnerships (MLPs) and other restricted partnership arrangements, is the increasing consolidation of the separate components in the same operation.

Here's why that's important: It allows normal market costs to be replaced with a kind of transfer pricing.

This type of pricing is why big oil companies used to try to control as many stages of the process as possible. This ushered in the age of the vertically integrated oil companies (VIOCs).

Some of these remain, but the climate is very different now.

For most companies today, specializing in their most efficient aspect - while also finding ways to associate cost controls with others - is the new mantra.

The companies that are succeeding are the ones that have put more of their costs within a new transfer pricing arrangement. These separate operations are no longer contained in the same corporate structure (the traditional meaning of transfer pricing), but accomplish the same result.

Therefore, in a market where oil prices are declining but demand still remains, some companies are going to see better bottom line results. In the end, you can bet it will be reflected in higher share prices for oil stocks.

The game is now less about the price of oil and more about the different strengths of each individual operator.

That "spread" is already improving our prospects for higher returns.

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