Rethinking the E&Ps

 | May 30, 2014 | 10:00 AM EDT
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The big head fake in energy (the one that has somewhat confused me) has been how the fantastic quarterly results from independent exploration-and-production companies has affected the domestic price of crude oil -- or how it has not affected it.

With massive production growth again in companies like EOG Resources (EOG), Cimarex Energy (XEC) and dozens of others, we've seen a glut of crude oil pour into the Mid-continent and literally search for a place to stay. While I've maintained that even a large influx of new crude wouldn't have enough power to crater the price action of the domestic West Texas Intermediate benchmark, I did bet heavily that the differential between domestic crude and global crude prices would increase. That just hasn't happened.

I made bets on the WTI/Brent spread at around $6, but I hoped that the killer reports on earnings would translate into a glut of supplies and a relatively weak WTI price, at least compared to a global Brent price that is still guided by upward geopolitical pressures in Libya, Ukraine, Iran and Iraq. But proving that oil trading is very tough indeed, the spread has virtually gone unchanged for the several weeks, remaining at $6 and confounding me and, I imagine, most of the other dedicated oil traders out there. Perhaps that is the charm, if there is one, in trading oil: Like Forrest Gump's box of chocolates, you never know what you're going to get.

What has happened has been a massive increase of crude transport by rail, taking excess supplies all over the country. To give an idea of just how much crude transport by rail has exploded in recent years, consider this: In 2008, less than 10,000 cars of crude moved in the U.S. For 2014, estimates are for more than 600,000 cars. Infrastructure in pipelines hasn't kept up with the U.S. production increase, but rail cars are doing well taking up the slack. One place the pipes have done well is in moving the massive glut of crude that existed in Cushing down to the Gulf Coast via the Seaway pipeline turnaround. Together, the financial outcome I've been looking for just hasn't happened.

But this has had a silver lining for some. For Gulf Coast refiners, it's meant that supply is vast and under price pressure, and that is the reason for the massive run of refiners like Valero (VLO), which has been a laggard in the refinery renaissance when all the crude was stuck in the Mid-con and Gulf Coast premiums were vast. Those premiums have entirely evaporated.

But it has also given strong new life to East Texas and Permian players, who I had figured were about to hit a wall on price and overproduce their advantage. With transport doing better than I had expected, we've seen continuing stock price appreciation for the aforementioned EOG and XEC. Meanwhile, Pioneer Natural Resources (PXD) was just upgraded (again) by FBR Capital with a $275 price target.

I have little left of these E&P shares; I trimmed most of my holdings with the Brent/WTI wager as they were part and parcel of the same thesis. And as reluctant as I am to add back to a position that was sold, it's now clear that there's more room for these stocks to run.

I won't bet the bank, and I hate to reinitiate positions, but even at these lofty numbers, you still have to be long the domestic E&Ps.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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