Fears of an economic slowdown prompted much of the selling; energy and other cyclical sectors suffered the worst losses. The S&P 500 Energy Index tumbled more than 20 percent in the third quarter, while more volatile Philadelphia Stock Exchange Oil Service Sector Index (OSX) gave up almost 29 percent, finishing the quarter at its lowest close since mid-September 2010.

Over the past few weeks, media outlets have run countless stories arguing that the stock market is close to a bottom because equities represent a good value at current levels. But investors should be wary of this sophistic argument: Stocks often become more overvalued on the way up than anyone expects and cheaper than anyone imagines on the way down.

This same rationale has burned investors who shorted Apple (NSDQ: AAPL) and Google (NSDQ: GOOG) during multiyear run-ups. By the same token, shares of Washington Mutual and other doomed financial institutions also looked cheap in 2008.

Instead, heed the words of John Maynard Keynes: “The market can be irrational a lot longer than you can remain solvent.” Valuations that appear cheap today can look downright expensive tomorrow if economic fundamentals and corporate earnings deteriorate.

That’s not to suggest that valuation metrics such as price-to-earnings and price-to-sales ratios are useless. Valuations tell us a great deal about the market’s expectations for a particular group of stocks. The missing element that links a stock’s valuation to its performance is a catalyst, or a development that changes the market’s perception of a particular stock or group for the better or worse. Check out this graph tracking the 12-month forward price-to-sales ratio for the OSX and the index’s actual price-to-sales ratio.

Source: Bloomberg

From 1997 to present, the OSX’s average price-to-sales ratio for the Oil Services Index is about 2.15. Today, the index trades at a price-to-sales ratio of about 1.7. Valuations have dipped below the current price-to-sales ratio on a few occasions over the past 14 years, including early 1997, late 1998 and late 2008 into early 2009.

Let’s consider the state of oil and natural-gas markets each time the OSX’s price-to-sales ratio slipped to less than 1.5.

In early 1997 and late 1998, oil prices sank to their lowest point during a bear market that lasted almost two decades. In December 1998, West Texas Intermediate crude oil (WTI) traded at about $11 per barrel–well off the 1980 average of roughly $37 per barrel (equivalent to almost $100 per barrel on an inflation-adjusted basis).

When the OSX’s price-to-sales ratio fell below 1.5 in late 2008 and early 2009, the world was mired in the worst economic contraction since the 1930s. The price of WTI collapsed from a high of almost $150 per barrel to a low of $31.41 per barrel in December 2008. Brent crude oil, a key international benchmark, plummeted to less than $40 per barrel from a high of about $140 per barrel in mid-2008.

The current pricing environment bears no comparison to either late 2008 or the late 1990s. As I pointed out in the Sept. 6, 2011, issue of The Energy Strategist Weekly, Why US Gasoline Prices Remain Elevated, local logistical constraints mean that WTI prices no longer reflect the global supply-demand balance for crude oil. Whereas WTI prices have slipped to less than $80 per barrel, Brent, Nigeria’s Bonny Light varietal and Light Louisiana Sweet crude oil all command more than $100 per barrel. Even a barrel of Mexico’s Maya blend–a heavy, sour crude oil–trades for roughly $92 per barrel.  

Although Brent crude oil has declined from its high of almost $130 per barrel in April 2011, current prices remain 25 percent to 30 percent higher than a year ago. At these levels, producers are unlikely to slash their drilling budgets.

The performance of oil services stocks hinges on how much major energy producers spend on exploration and production. One of the best gauges of global drilling activity is the weekly active rig count from Baker Hughes (NYSE: BHI). Here’s a look at the US and international rig counts over the past five years.

Source: Bloomberg

As you can see, there’s no sign of weakness whatsoever in either US or international drilling activity. However, the decline in WTI prices could weigh on drilling activity in the Bakken Shale and the Canadian oil sands–two regions with exposure to this market. However, to date, North American drilling activity remains robust, especially in oil-rich plays.

International drilling activity, which tends to hinge on the price of Brent crude oil, has ramped up considerably in recent years to levels last seen in the mid-1980s.

The recent surge in the Middle East’s rig count is particularly encouraging for the oil services industry. Major integrated oil companies and national oil companies (NOC) such as Saudi Aramco have launched a number of multiyear development projects. With bulletproof balance sheets, NOCs and international oil companies aren’t phased by a 10 percent or 15 percent decline in oil prices. The prevailing logic suggests that Brent prices would need to decline into the low $80s per barrel for international drilling activity to contract. Even in those circumstances, a 2008-style collapse remains highly unlikely.

Meanwhile, some ill-informed commentators continue perpetuate the myth that the world is awash in excess crude oil and that oil prices will collapse. With the exception of the US Mid-Continent where WTI is king, the global supply-demand balance for oil remains tight.

Although the International Energy Agency (IEA) has lowered its 2011 and 2012 forecast for oil consumption growth, the agency still expects global demand to grow by 1 million barrels per day in 2011 and 1.4 million barrels per day in 2012.

Meanwhile, IEA has also lowered its outlook for global oil supply growth. The agency’s Dec. 10, 2010, Oil Market Report called for non-OPEC oil production to increase by 600,000 barrels per day to 53.4 million barrels per day in 2011. But a series of project delays and production start-up issues in the North Sea, China and elsewhere prompted the IEA to revise its estimate of non-OPEC supply to 52.8 million barrels of oil per day.

Libya’s civil war has weighed heavily on OPEC oil supply in 2011. The IEA estimates OPEC would need to produce about 31.3 million barrels of oil per day in the third quarter to balance supply and demand. The cartel produced about 30.3 million barrels of oil per day in the third quarter. In the Oil Market Report issued on Sept. 13, 2011, the IEA noted that countries had dipped into their oil inventories to make up for this shortfall:

[Oil] stocks fell below the five-year average for the first time since the economic recession of 2008. Preliminary data indicate that Organization for Economic Co-operation and Development (OECD) stocks remained tight in August, rising by a modest 0.6 million [barrels per day].

The world does not face an oversupply of oil. Tightness in global oil markets also explains why the price of Brent crude oil has remained elevated despite fears of a global economic slowdown.

Bottom line: The Philadelphia Stock Exchange Oil Service Sector Index is approaching valuations that that historically have marked important lows–with the exception of the meltdowns witnessed in 1998 and 2008. Even if the US slips into recession, global oil demand or prices won’t collapse to the extent that they did in late 2008 and early 2009.

Brent crude oil is unlikely to fall below $90 per barrel, a level that suggests the OSX might only have another 5 percent to 10 percent of downside before it bottoms.

Ongoing concerns about global economic growth could weigh on the subsector for a few more weeks. But oil services stocks should enjoy two major upside catalysts over the next month and a half.

If oil services names once again report an uptick in international activity during third-quarter earnings season, net income and revenue could surprise to the upside. If EU policymakers announce additional measures to address the eurozone’s sovereign-credit crisis, oil services stocks–and the broader market–should rally. Such a plan may emerge before the G-20 summit slated to take place on Nov. 3 and Nov. 4.

Around the Portfolios

Proven Reserves Portfolio holding Chevron Corp (NYSE: CVX) made its final investment decision on the AUD29 billion (USD28.4 billion) Wheatstone liquefied natural gas (LNG) project in Western Australia. Chevron owns a 73.6 percent equity stake in the endeavor, while its minority partners include Apache Corp (NYSE: APA), Kuwait Foreign Petroleum Exploration Company, Royal Dutch Shell (NYSE: RDS.A) and Kyushu Electric Power Company (Tokyo: 9508).

When the first phase of the project comes online in 2016, the facility will have the capacity to produce 8.9 million metric tons per annum (mmtpa) of LNG. The completed project will have a peak capacity of 25 million mmtpa. The deal underscores rising demand for LNG in Asian emerging markets, as well as South Korea and Japan. Buy Chevron Corp under 100.

Italian integrated energy company Eni (Milan: ENI, NYSE: E) on Sept. 26 indicated that it had restarted production at 15 wells in Libya’s Abu Attifel field. Output from these operations stands at roughly 32,000 barrels of oil per day, compared to about 70,000 barrels of oil per day before the Libyan civil war. Although this is a positive first step, management acknowledged that it could be some time before production reaches former levels. Buy Eni’s American depositary receipt up to USD45.

Don’t miss out on this unique opportunity to hear me, Roger Conrad, Yiannis Mostrous, Benjamin Shepherd, David Dittman and Jim Fink share their latest insights on the markets and economy. Join these investing experts at Investing Daily’s 2012 Wealth Summit at the luxurious Four Seasons Hotel in Palm Beach, FL on May 4-5, 2012.

With the US economy likely to grow at a lackluster pace over the next few years, expect the stock market to suffer through a period of extreme volatility as investors adjust to the new normal. The EU’s ongoing sovereign-debt crisis will also continue to enervate investors. Throw in “Black Swan” events such as the civil war in Libya, and it’s easy to see why investors are on edge. A fearmongering media that focuses on worst-case scenarios rather than the likely outcomes doesn’t help matters.

But Investing Daily’s 2011 Wealth Summit will give you the edge in these uncertain times. This year’s event will focus on winning investment strategies that generate profits in both up and down markets. To learn more about this must-attend Wealth Summit, go to InvestingSummit.com or call 1-800-832-2330 for more details.

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Running with Da’ Bears and Da’ Bulls

Bears and bulls alike are invited to join Elliott Gue and Roger Conrad at the Hilton Chicago Hotel for The World MoneyShow. The events get underway on Oct. 20 and last until Oct. 22. As this new era of investing unfolds, smart investors know it’s imperative to stay informed and educated. Planning to join me in Chicago? Click here or call 800-970-4355 and refer to priority code 023653 to register as a guest of The Energy Strategist.