Backwardated

"ExxonMobil stock should never have a down day in the
market for the next five years…Not ever, ever, ever," a
friend exaggerated yesterday.  "This thing is ridiculously
cheap. The stock dropped a buck last Thursday, even though
the oil price gained a dollar.  Investors should have been
buying the stock, not selling it. They should be buying
this thing…EVERY DAY!"

"Yeah, I hear you," your editor replied. "Certainly, the
stock is cheap if oil prices don’t fall. Of course, almost
all oil stocks are cheap…unless oil is heading to $30 a
barrel."

"No way!" the friend countered. "No way! Oil’s not going to
$30. The crazy thing is that Wall Street is still basing
its earnings projections for Exxon on $35 oil.  No one
seems to believe that these oil prices are sustainable."

"I know. It’s pretty amazing," your editor continued, "Wall
Street analysts can’t seem to acclimatize themselves to the
idea that commodity prices sometimes go up, instead of
down. They still see $35 oil as the ‘right’ price, rather
than an anachronism…They’ve been clinging to the fantasy
of perpetually cheap oil like a 2-year-old clinging to a
"blanky.’"

"Right," the friend agreed, "but by the time Wall Street
figures out that $35 was actually the ‘wrong’ price on
which to base earnings estimates, most oil stocks will be
much higher than they are today."

"No argument," we replied, "but you could say the same
thing about almost ANY resource stock. The entire commodity
world seems to be in backwardation – both the futures
prices and the earning’s estimates."

"What do you mean?"

"What I mean is that skepticism toward commodity prices is
pandemic. Most of the commodity futures markets, for
example, anticipate FALLING prices. At the same time, Wall
Street expects earnings to fall year after year for almost
EVERY resource company.

"In the futures markets, the prices for crude oil and
natural gas and gasoline are all in backwardation to some
extant – that is, the near-term contracts are higher than
the distant contracts. So crude oil for delivery in May
costs $54.55 a barrel, whereas oil for delivery three years
from now costs only $49.60. This bearish pricing
configuration would not seem so unusual, if not for the
fact that oil has been in a powerful bull market for more
than three years.

"What seems a bit more unusual," your editor continued, "is
that Wall Street’s estimates for most resource companies
reflect even MORE pessimism toward future commodity prices
than do the futures markets themselves. Tesoro Petroleum is
a perfect example. Wall Street analysts expect this oil
refiner to book about $3.40 per share in profits both this
year and next. But then the consensus estimates plunge to
$2.80 on 2007 and $1.80 in 2008."

"Whatever happened to Wall Street’s congenital optimism?"
your editor’s friend quipped.

"Good question."

We do not know why Wall Street has been so slow to
acknowledge the commodity bull market, dear investor. But
whatever the reason, we suspect that the conspicuous
absence of optimism toward commodity prices presents an
attractive investment opportunity.

Consider the startlingly divergent expectations for
ExxonMobil (NYSE: XOM) compared to Citigroup (NYSE: C).

Last year, Exxon earned a bit more than Citi. Nevertheless,
Wall Street expects both companies to earn about $4.20 a
share this year. Then in 2006, the consensus expects
Exxon’s earnings to FALL to $4.02 a share, while
Citigroup’s RISE to $4.67 a share. And as the chart below
shows, Wall Street expects Citigroup to continue outshining
its oil-pumping counterpart until at least 2008.

According to the Wall Street clairvoyants, Citigroup will
earn almost $6.00 a share in 2008, while Exxon’s earnings
will wither to a mere $3.58 a share. In other words, even
though these two companies are expected to earn a nearly
identical amount per share this year, and even though
interest rates are rising almost as fast as crude oil (a
trend that is not celebrated at Citigroup headquarters),
Wall Street expects Citigroup to earn 66% MORE than Exxon
by the end of 2008. If forced to choose, we think we’d take
the other side of that trade.

A couple of savvy sell-side analysts from Goldman Sachs
recently attempted to put a price tag on Wall Street’s
skepticism toward the oil stock sector:

"The futures market suggests oil will average more than
$50/barrel in 2006, well above the $35 assumption used in
consensus EPS estimates," observe Goldman Sachs analysts
David J. Kostin and Maria Grant.  "Current estimates
suggest energy earnings will decline by 4% in 2006 compared
with a 10% rise for the S&P 500. [But] if the futures
market is correct, energy analysts will have to boost EPS
estimates by an average of 76%.  Applying the average key
multiple over the past 18 years to revised estimates
results in a 140% potential price gain. Even assigning the
lowest key multiple since 1987 to revised estimates
suggests 11% appreciation."

Not surprisingly, therefore, the Goldman duo advises
investors to "buy energy stocks to benefit from high and
rising oil prices."

We suspect investors could buy energy stocks, just to
benefit from flat to directionless oil prices. If oil
prices merely stand still for the next two years, oil stock
investors should fare very well. But, of course, oil prices
– like most commodity prices – do not usually stand still.
They are as volatile as a teenager who has been grounded
for the weekend.

On the other hand, commodity prices are also prone to
advancing or declining in line with 18-year cycles.
"Commodities and paper assets (like stocks and bonds and
paper currency) trade off price leadership in cycles
averaging 18 years each," observes analyst Barry Bannister
of Legg Mason Wood Walker, "the result of the pressure
inflation places on paper asset values."

"Commodity cycles are triggered by three things: (1) a long
period of underinvestment by commodity producers; (2) a new
user of commodities emerging; and (3) the pressure to
devalue a reserve currency to pay for war, legacy debt
burdens and social costs."

If Bannister’s compelling theory holds true, the current
commodity bull market could run for another 10 to 15 years
before returning the baton to "paper assets." But even if
the current commodity bull market perishes in its prime, it
should last for another two or three years at least…That
should be more than enough time to make some money betting
against Wall Street’s skepticism.

Did You Notice…?
By Eric J. Fry

Not all oil stocks are created equal. Over the last twelve
months, for example, while the XOI Index of major oil
stocks has advanced 45%, the S&P Refining Index has soared
nearly 80%. The nearby chart suggests refining stocks might
continue to outpace their energy industry counterparts for
a while longer.

U.S. distillate inventories are falling relative to crude
oil inventories. In other words, the inventory of refined
products that comes OUT of the refineries is falling
relative to the inventory of the crude oil that goes IN to
refineries. The lean distillate inventories have helped to
boost many refined products to record-high prices. As an
extreme oversimplification, therefore, refining
profitability tends to improve when distillate inventories
fall relative to crude inventories.

We should also point out that distillate inventories have
been dropping recently, despite the fact that U.S.
refineries have been running "flat-out" for most of the
last 12 months. So boosting inventories will not be easy.

Net-net, U.S. refiners seem to enjoy an enviable position
within the energy industry. Wall Street may distrust the
bullish realities of U.S. oil refining – as evidenced by
its downbeat earnings estimates for Tesoro Petroleum – but
Mr. Market seems to be a true believer.

Barrels of Oil, Miles of Mud

And the Markets…