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Investment Ideas

How to Play the Texas Tea Momentum

In May 2008 a call from a major brokerage was heard round the world. It was the “super spike” in the price of oil which called for prices to dramatically increase from the $115 level to an unthinkable $150-$200 a barrel. This call came from the same analyst that three years earlier saw $100 barrel crude when sweet Texas tea was hovering close to $60. The earlier call was also a somewhat unthinkable prospect.

Recently, we got another call from the same brokerage… just a different analyst this time. The call isn’t quite the same, but the idea is. Oil prices are expected to move higher. We will leave the details of Iran or supply and demand out of this discussion and focus on how we can best position our portfolio based on this move.  Of course you'll need to agree with the basic thesis that oil will be moving higher and have some faith in Goldman Sach's and thier research.

Who Benefits
The immediate thought of who benefits rests with the largest players in the oil patch. Chevron (CVX - Analyst Report), Exxon Mobil (XOM - Analyst Report) and ConocoPhillips (COP - Analyst Report) come to mind. The services like Halliburton Company (HAL - Analyst Report) and Schlumberger (SLB - Analyst Report) could also see some benefit as a result.

One area that could see exaggerated benefit would be the drillers. As oil prices continue to increase, the willingness of speculators to search new sources of oil should lead to gains for the drillers. Those that are succesfull at new holes in proven reserves are even more attractive.  Diamond Offshore Drilling (DO - Analyst Report) at $9 billion carries a small multiple of 9x trailing earnings and is one of the largest drillers. As one of the biggest drillers, the stock is protected from large price swings via diversification.

Nabors Industries (NBR - Analyst Report) is another driller that is a little smaller Diamond Offshore Drilling at $6 billion in market capitalization. A 10 year chart of NBR points out just how the drillers of smaller size can be affected by a super spike in oil. From early January of 2008 through late June 2008, NBR nearly doubled.


Drilling deeper into the segment we reach Rowan Companies (RDC - Analyst Report) with a market capitalization of $4.8 billion. This stock did not see the same spike that NBR saw in the 2008 time frame, mostly because it is diversified into forestry and steel products.   Again, it's all a matter of preference and exactly how much pure exposure you want to oil.  

For the most speculative out there, the small (wildcat) drilling companies can offer the some great potential returns, but also carry significant risks. Pioneer Drilling (PDC) is about $600 million in market capitalization and already trades at a lofty 50x trailing earnings. Its small size make it a potential M&A play as well, but this stock does not come without its inherent risks. As the price of oil returned from its super spike, PDC saw its stock react like a gusher – a gusher that lost all of its pressure. The stock slid from a high of $20 in June 2008 to $6.75 in October of the same year and that wasn’t the bottom. Mid-March of 2009 saw the stock reach rock bottom around the $3.50 level, a move that underscores “what spikes up, is likely to spike down.”


Who has the most to lose?
When oil spikes, the cost of fuel soars. Airlines generally feel the effect of higher fuel costs more than other transportation stocks as they have no other alternative fuel sources and in a tough economic envirnment not much room to raise prices on consumers. Many will view this as yet another reason to not own an airline stock, as most airlines end up losing money and or going bankrupt.

Another segment of the economy that gets hit during oil super spikes is the automotive segment. Car makers saw sales of SUV’s and other gas guzzlers plummeted in 2008 as consumers looked for better gas mileage.  Higher energy costs in general will hurt major manufacturing companies like the auto-makers as well because of increased production costs which equate to higher margins. 

Ford (F - Analyst Report) saw its stock crumble during the super spike. There were other factors that lead to the debacle that was the US auto industry, but 2008 saw F move from a high of $8 to $1.50. Don’t think that the US auto industry was alone, Toyota (TM - Analyst Report) also saw a “super spike” of its own. Shares of the Japanese car maker slid throughout all of 2008, but saw a sizeable spike downward late in the year losing one third its value.

Conclusion
Higher oil prices pump a crimp on all spending in the US economy, but some sectors feel the pain more than others. Airlines and automakers bear the brunt of it, but higher fuel costs send prices higher on just about everything from food to computer parts. That does not mean we cannot find a few areas of strength to take advantage of big moves in the price of oil.  Alternitives like wind, solar and nat gas should also see a rise in prices.  Look for the "best in breed" in each alternitives sector to be rewarded if oil prices continue to rise.  

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