Same Song, Different Party

You may have noticed that, 1) it is election season and, 2) gasoline prices are declining. This has some pundits attempting to connect the dots to imply that somehow President Obama is manipulating gasoline prices in order to win elections.

It doesn’t matter which party is in office, these accusations always seem to pop up at election time. It happened when Clinton was in office, it happened when Bush was in office, and now it’s happening while Obama is in office. The only things that change are the party that is being accused of manipulating prices, and the partisans defending or accusing that party. This year it’s Fox News doing the accusing, and MSNBC defending.

But as I have pointed out many times, there are fundamental, predictable reasons for the tendency of gasoline prices to decline at this time of year. This happens most years, even in non-election years. Gasoline prices fell at this time of year in 2011, 2012, and 2013 — two of which were non-election years. It is just that the political accusations only arise during election years.

Why Gasoline Declines in Fall

Gasoline prices fall at this time of year for three reasons. First, summer driving season is over, and demand is typically declining at this time of year. At the same time, the gasoline specifications switch over to a winter blend that is cheaper to produce. Further, these winter blends contain a higher percentage of an ingredient (butane) that is available in greater abundance. See my article Why Gasoline Prices are Falling for a more thorough explanation of this issue.

So we have lower demand, lower production costs, and greater supplies all converging at about this time every year. This year, add in the fact that oil prices have retreated sharply since summer, and the confluence of factors has driven gasoline prices to their lowest level in four years.

In some years, extraordinary circumstances can override this general tendency of price declines in the fall. Hurricane Katrina in 2005 took a large fraction of oil production offline in the Gulf of Mexico at a time that the oil supply was already tight, and this drove oil prices sharply higher. So that year we didn’t see the typical fall price decline.

The President Is Not an Energy Tsar

Presidents can enact policies that influence the price of gasoline in the long term, but there are only a couple of ways a president can influence short-term gasoline prices, and both are very public. A president can announce a release of crude oil from the Strategic Petroleum Reserve (SPR) to flood oil into the market and depress prices. President Clinton actually did this leading up to an election, so the charge that he attempted to manipulate prices has some basis.

A president can also convince Congress to temporarily lower the federal gasoline tax in order to reduce gasoline prices. Again, that would be an obvious attempt to gain political favor if done just before election, and it is a gimmick that John McCain and Hillary Clinton both proposed when they were running for president.

Who Benefits?

Regardless of the cause, oil and gasoline prices are falling, and that’s boosting the  economy by giving consumers more discretionary income just ahead of the holidays. Retailers should be among the biggest beneficiaries.

On the other hand the stocks of companies that produce oil and gas are getting hammered, while those that rely on oil, natural gas, or refined products (e.g., gasoline) as inputs should see earnings improve. This includes airlines, trucking companies and marine shipping.

Also, as I have pointed out previously (see Rocket and Feathers), within the energy industry oil refiners usually benefit from falling oil prices, because they are generally able to widen their margins as oil prices fall. In fact, many refiners are now reporting earnings that are much better than expected.

For example, last week refiner Tesoro (NYSE: TSO ) reported adjusted earnings of $3.06 per share, much higher than the consensus estimate of $2.15, and far ahead of the year-ago quarter adjusted earnings per share of 44 cents. This week Valero (NYSE: VLO) also handily beat estimates, more than tripling their profit from the same quarter in 2013.

By the same token, integrated oil and gas companies will generally outperform pure oil and gas companies when oil prices are falling, because their refining divisions will help offset the decline in upstream operations that results from falling prices.

Conclusions

Oil and gasoline prices are falling, for reasons much more obvious and rational than political manipulation. Such conspiracy theories have no basis in fact. Gasoline prices generally decline in the fall, and conversely rise in the spring just ahead of summer driving season.

Investors should take heed of the industries that will benefit from the decline in energy prices. Although I am extremely bullish on the long-term prospects of the energy sector, the sector is cyclical. It is important to pick your entry points during the down cycle. There are times that the sector will underperform. As a result, even though I always keep money in the energy sector, over 70% of my own portfolio is invested outside the sector. Within the energy sector, the refiners are presently outperforming the rest of the sector.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Emerald Oiled Again

As detailed in the last Energy Strategist, small-cap Bakken driller Emerald Oil (NYSE: EOX) was already dirt-cheap at $3.30 a share, priced near the value of the crude likely to be extracted from the few wells it had already drilled as of the end of last year.

Now, after a further decline of 20%, the stock is pricing in refinancing difficulties for a company with no debt due until 2019, modest interest costs and sufficient liquidity to finance all of next year’s capital spending.

Emerald delivered as expected on its third-quarter earnings report, not that that mattered with crude crashing below $80 a barrel.

The company remains on track to double last year’s production in 2014 and is projecting an output increase of at least 35% in 2015. That’s factoring in plans to drop one of its three rigs in March unless crude prices have recovered by then.

Even at the reduced drilling pace that would follow, Emerald expects to end up with 85% of its Bakken acreage held by production by the end of 2015, and 100% three months after that. At that point it will be free to resume drilling the most promising locations first. The entirety of the company’s $225 million drilling budget for next year can be covered from cash on hand and an untapped $200 million credit line that’s likely to increase to $250 million by year’s end.

In other words, Emerald doesn’t need to sell equity or raise debt to keep converting its Bakken turf into bankable reserves and rising cash flow from operations. It just needs the price of crude to stabilize north of $70 a barrel, which would sustain its development but not the costlier offshore projects that remain essential to meeting long-term global demand.

The opportunity to pick up shares here well below liquidation value is ripe for aggressive bargain hunters with a stomach for near-term losses. We’re making Emerald the #11 Best Buy to underscore our conviction. Buy EOX below $4.50.   

— Igor Greenwald