Oil Stocks Are Nearing New Heights. It’s Time to Be Careful.

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Oil stocks are approaching levels not seen in years as the price of the fuel surges and shows little sign of backing down. That is a danger signal.

The

Energy Select Sector SPDR Fund

(ticker: XLE) gained as much as 2.6% Monday before dipping into the red as the broader market sold off more sharply. The fund, home to oil producers like

Chevron

(CVX) and oil-services companies like

Halliburton

 (HAL), is up 31% for the year. Monday, the fund’s share price touched just above $77, approaching $78.91, a closing level it hasn’t reached since 2015. 

West Texas Intermediate crude oil, the benchmark grade in the U.S., is up just under 60% for the year. Demand for oil is expected to grow as the economy bounces back from the pandemic, and now Russia’s attack on Ukraine is adding to the gains. Markets see a strong possibility that western countries will sanction Russian oil, which would reduce the amount available on the international market and bring the price higher. 

If it sounds like a great time to invest in the oil patch, watch out. Oil stocks could be ready to implode. 

First off, the futures market is in “backwardation,” which is when the price of oil for delivery right away, or soon, is higher than for oil to be delivered months from now. Futures on oil for delivery in July 2023 are trading for $87, compared with $119.40 for April crude. 

That makes sense. A surging oil price might correct itself, as consumers back away from spending on gasoline to protect their wallets. The higher prices go, the more incentive oil companies have to extract barrels from the ground, and the more wells that were once uneconomical can be pumped at a profit. Plus, central banks around the globe are set to lift interest rates to combat high inflation across the board, which could cause oil prices to decline by slowing economic growth. 

All that is a bad recipe for both oil producer and services stocks. Oil producers generally see lower profits when the price of oil falls, of course. And companies in oil services depend on higher budgets from the producers, which can invest more in order to sell more oil at the currently higher price, explained Bill Selesky an oil analyst at Argus Research.

Expectations for higher budgets explain this year’s 50% move higher in Halliburton stock and a 32% gain in 

Schlumberger NV

(SLB), but if those budgets don’t come to fruition, the services stocks could fall. If oil producers do invest more, the added supply could further reduce the price of oil, which is already expected to dip. 

The potential downside looks bleak. Selesky says the group of stocks he covers could fall 40%, judging by the prices those shares were selling for a year ago, when the price of oil was far lower. The oil fund was trading at $53 a share, about 30% blower than its price Monday. That is mostly because a year ago, the price of WTI oil was about $65 a barrel. 

Oil stocks may be able to keep gaining, but there is lots of room for them to fall.

Write to Jacob Sonenshine at [email protected]