Trader Talk

Why the oil price spike is a risk for markets

Andrey Rudakov | Bloomberg | Getty Images

Oil spiked on Tuesday as Russia's Interfax news agency said that Russia and Saudi Arabia had agreed on a production freeze ahead of the upcoming OPEC meeting in Doha, regardless of whether other OPEC members participate or not.

Oil immediately spiked to its highest level since December. More importantly, it moved over the 200-day moving average for the first time since October 2014.

In a range-bound market, a breakout to new highs is a big story.

Never mind that neither the Russian nor the Saudi oil minister confirmed this story. Traders seemed to have convinced themselves that there will be a deal out of Doha.

These countries could threaten Doha oil deal

What's all this mean for energy stocks? It's a bit of a conundrum. Higher oil is certainly good news. But the stocks are reflecting that.

Chevron, for example, which is highly leveraged to oil, has gone from $75 in January to almost $100 today and is is trading at 70 times 2016 earnings. That's right, 70 times earnings.

What does it mean? It means that traders are pricing in much higher crude oil in 2017.

Those who are more bullish keep telling us reporters to stop talking about price to earnings ratios, that the new paradigm is to look at free cash flow, and that "price to cash flow" is a proper valuation metric. Under this argument, Chevron has had negative free cash flow for the last four years: they have to borrow to pay their dividend. Under this metric, free cash flow is supposed to turn positive in 2017, a very positive sign.

Maybe. Here's a rule of thumb I have learned from a couple decades of watching this stuff: when someone tells you there is a new paradigm that you should be watching to value something, check to make sure your wallet is still in your pocket.

Back to Doha: it's a high-stakes game. There is big pressure for a deal in Doha, even without all the participants. In a worst-case scenario, without some kind of understanding on production there could be an all-out price war that could destabilize regimes in the Middle East.

In one sense, the Saudis can claim a victory. The central objective of the Saudi strategy — to dramatically cut the growth of U.S. shale production — has achieved its objective. Rig counts have collapsed.

But in the long-term, it is clear this is not going to work. Shale production is here to stay because shale is a technology play, and the technology keeps getting better. For example, right now Oppenheimer's Fadel Gheit estimates that roughly half of U.S. shale oil production is uneconomical. But a year from now, assuming the price of oil stays the same, he estimates that only 20 to 30 percent will be uneconomical. The technology keeps getting better.

That's why it's unlikely oil will go back to $100. Shale is the great shock absorber for higher oil.

What about the future? The market seems to believe that this production freeze that is on the horizon is a prelude to a production cut. This seems like more wishful thinking, at least in the near future. Just getting everyone to cap production would be a feat. Just getting everyone to adhere to a cap would be an additional feat.

Here's how to look at Doha: the markets are already pricing in a deal. That means there is significant downside risk to oil and energy if no deal emerges.