In my article titled Oil Prices Gone Wild posted June 9th, I spoke about how oil prices seemed to have gotten ahead of themselves. Prices defied gravity when they soared from $100 per barrel to just over $138 per barrel (when I wrote the article) over the course of only a few days. At this point I figured a massive correction was necessary to bring these prices back in line with the long term trend. Well, with oil prices down 18% from their peak, and natural gas prices down over 30% from their peak it looks like we’ve got that correction. But is it over? Is this just your typical bull market correction? Or is this really a bursting bubble caused by “demand destruction” (thanks CNBC for that overused buzzword).

Personally, in the case of crude oil, I think this is just a typical correction in the long term bull trend. Sometimes I find it helps to take a step back and look at the bigger picture. The chart below shows the price of oil going back to 2004.

From looking at this chart, the long term bull trend appears to have gotten ahead of itself when oil made the move from $100 to $145 – this shouldn’t come as a surprise to anyone. But as long as crude oil can hold on to $100/barrel then I would think the long term story for oil seems sound.

What does this mean for oil equities? Well, with oil prices north of $100 per barrel, these companies turn themselves in cash generating machines. Typically oil/gas companies hedge their production 6 months to 1 year out. In other words, they pre-arrange a price to sell the oil and natural gas they produced. Given the arrangement was made in the past, the prices that were agreed upon are usually much lower than where current market prices are sitting (assuming prices have increased). And even at the lower prices that companies hedged at, they still manage to achieve record earnings, quarter after quarter.

So what’s the excuse the media is using for this correction? The media likes to point to demand destruction – the reduction in demand caused by higher prices. It’s classic economic theory… and it’s hard to argue with. In North America we have indeed seen some degree of demand destruction – people are driving fewer miles, people are beginning to make the switch from SUVs to more fuel efficient cars, and auto sales are plummeting. But that’s just North America. In other parts of the world (specifically emerging markets and the Middle East), the buzzword could very well be demand explosion.

In my previous article I also spoke about the government subsidies for gasoline and energy in emerging markets and how those subsidies may eventually become too burdensome forcing these governments to eliminate them, thus causing real “demand destruction”. (Note: more than half of the world’s population pays less than the prevailing market rate for oil and natural gas because of these subsidies.) There’s certainly the risk that may happen, but the longer we sit here in a +$100 per barrel oil environment, the more I start to think that subsidy cuts aren’t coming. Any cut to the subsidies would have to be gradual – these emerging market governments must know that drastically cutting them would be economic suicide. Besides, it’s not just China and India who are benefiting from government subsidies. The Middle East subsidizes the price of energy more than anywhere else in the world. And since these nations are oil producers, they’re rolling in money – they probably don’t think twice about the cost of these subsidies.

Natural Gas
What about Natural Gas? The price of nat gas has seen a huge correction. But again, I still think the long term bull story for nat gas is there. Why be bullish on natural gas? Because the world needs energy, and we’re running out of oil. In addition, the world need clean energy, and natural gas certainly burns cleaner than oil or coal. Ok, so what’s cheaper, natural gas or crude oil? Well, natural gas costs $8.73 per Mcf (thousand cubic feet). Roughly 6.0 Mcf equates to 1 BOE (Barrel Of Oil Equivalent), which as we all know sells for $118, as of today’s close. So, on a straight BOE basis, natural gas costs about $50.63. In other words, with $118 you can buy 1 barrel of crude oil or you can buy 2.33 “barrels” of natural gas. The chart below shows this relationship (how many “barrels” of natural gas you can buy with 1 barrel of crude oil, going back 10 years). This should give us a pretty good picture of how cheap (or expensive) natural gas is on a relative basis versus crude oil.

Even after the latest sell off, crude oil is still the most expensive it ever has been (on a relative basis versus natural gas) in 10 years. Back in late 2000 you could only buy 0.50 “barrels” of natural gas with 1 barrel of crude oil. With the push for cleaner energy, one would expect this relationship to begin moving in favour of natural gas as nat gas becomes more valuable to the world.

To summarize, I still think the long term bull trend for oil and natural gas is in tact and both have very strong fundamental stories. Oil and natural gas equities like Advantage Energy Income Fund (TSE: AVN.UN) who have steady production of oil and natural gas (weighted more toward natural gas), are sitting on very attractive potential reserves, who have underperformed their peer group and now appear cheap, and operate in politically safe environments look very attractive in this environment. Furthermore, nearly all oil and gas producing equities never responded positively when crude oil prices shot past $100 to $145 per barrel. Most are still trading at levels at or below where they were when oil prices were at $100 per barrel. There may be a few more days/weeks of oil/gas bear market talk, but I would seriously start considering adding positions in some of these companies. I think it’s a little comical that we’re talking about the collapse of the oil market when oil is still trading (well) above $100 per barrel.

One thing I’ve learned during my time dabbling in the markets is that the media can prove to be a very good contrarian indicator. When calls for the end to the oil bull market begin making the headlines, that’s when you know the market has been oversold and it’s time to buy.

Ownership Disclosure: I currently own units of Advantage Energy Income Fund (TSE: AVN.UN).

Disclaimer: Any information contained in the above article represents my opinions only, and should not be construed as personalized investment advice. I cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of the article bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice.