Higher Oil Prices Could Punish These Stocks

Posted: Nov 13, 2011 12:49 AM

A recent front-page article in The Financial Times warned of the prospects of $200 oil. The respected financial publication predicted that any further tensions between Iran and the West -- including a bombing raid by Israel to take Iran's nuclear facilities off-line -- would quickly create chaos in the oil pits. After all, Iran is the world's third-largest exporter of oil (after Saudi Arabia and Russia), so any shutdown of oil production in that country would create a sharp shock in the tenuous balance between supply and demand.

It doesn't help that Libya's production remains well below recent peaks, and Yemen and Syria are seeing turmoil-related drops in oil output. These problems have already led to a too-lean oil inventory environment in Europe, even in the face of weak demand.

But it's time to dispel this skyrocketing oil price myth: $200 oil is unlikely to ever happen.

First of all, Iran's nuclear threat has been in place for awhile. Israel has made noise about a preemptive strike for several years but would greatly prefer the United States to take the lead on any military action. Meanwhile, the United States has shown to have little appetite for any such confrontation and would probably seek to ratchet up current sanctions instead.

More important, oil prices at $200 would deal a crippling blow to the U.S., Asian and European economies long before it reached that mark -- regardless of whether such a conflict takes place. Indeed, by the time we got to $125 oil, a global recession would likely already be under way. By the time we got to $150 oil, demand would slump down to the level of supply. So it's highly unlikely that we'd see $200 oil anytime soon. (I am referencing West Texas Intermediate crude prices, which currently fetch about $95 per barrel. Brent Crude, a European benchmark, is typically about $20 higher).

The usual suspects
Still, this is nothing to cheer about. For investors already questioning whether the U.S. economy can expand in 2012, this headwind can answer the question -- in the negative.  As I've written before, this would certainly create real trouble for automakers such as Ford (NYSE: F) and GM (NYSE: GM) as well as airline carriers such as Delta Airlines (NYSE: DAL), Southwest Airlines (NYSE: LUV) and American Airlines parent AMR (NYSE: AMR).

Most of the stocks in these sectors are quite cheap right now, trading for less than 10 times projected profits. But these profit forecasts would be sharply reduced and, in the case of airline stocks, profit forecasts would possibly morph into loss forecasts. So investors shouldn't take current price-to-earnings (P/E) ratios as a basis for investment quite yet. Indeed, a move above $100 for oil would set off selling pressure in these sectors.

Other stocks that will feel the pinch
Other sectors are also at risk. Restaurant chains such as Brinker (NYSE: EAT), which operates the Chili's restaurant chain, and Darden International (NYSE: DRI), which operates Red Lobster, Olive Garden and other chains. When oil prices surged in 2008, causing gasoline prices to hit $4 a gallon in many regions, these chains saw a sharp drop in customer traffic.

To give you a sense of the vulnerability of these types of firms, take a look at the earnings profile of Brinker. Analysts expect the company to earn just under $2 a share in fiscal (June) 2012, and just over $2 a share the following fiscal year. Yet from fiscal 2007 to fiscal 2008, the last time oil spiked, earnings per share (EPS) dropped 75%, from $1.70 to $0.43.

Trucking firms are also an area to avoid -- and possibly short. During the last oil spike, these firms tried to pass on the big increases in diesel fuel prices with fuel surcharges, but customers responded by simply lumping more shipments together to pay for fewer trips. This pushed some firms such as YRC Worldwide (Nasdaq: YRCW) to the brink of bankruptcy, while most other trucking firms shifted from profits to losses.

Yet it's the firms that count on consumer discretionary spending that are the most vulnerable, since a move toward $5-a-gallon gasoline would eat up the money consumers could have spent elsewhere. Six Flags Entertainment (NYSE: SIX), as an example, is expected to generate a modest profit in 2012 on roughly 6% revenue growth. But this forecast would likely evaporate if oil prices moved up 20% or 30% from current levels. For a company that has generated negative free cash flow for six of the past seven years, this would be an unwelcome turn of events.

Risks to Consider:  The possibility for a dramatic ratcheting-down in the price of oil is remote. Regardless of the tensions over Iran's nuclear ambitions, the usual pressures on oil prices remain. But if it does happen, then some of these stocks may turn from losers into winners. If you sell these stocks, that's one thing -- you simply missed out on a gain. But if you choose to short one or two of these stocks, then you might have to cover your position at a loss.

Action to Take --> It's time to stress-test of all your holdings to see whether they are heavily exposed to crude oil. You can hedge the exposure to oil by buying the Barclays iPath S&P GSCI Crude Oil TR Index fund (NYSE: OIL), which would gain in step with oil prices. More broadly, you need to closely monitor oil prices in coming weeks. If they keep rising, then it's time to question whether the U.S. economy can avoid a recession in 2012, which would have far-reaching implications for a wider range of stocks.


This article originally appeared at www.streetauthority.com.