Where could major oil stocks head next?

Silhouette of an oil rig

It’s been a shaky few weeks for major oil stocks. Giants like BP, Shell and glencore all experienced above-average volatility in their stock price movements. This is linked to the underlying movements in the price of WTI and Brent crude oil. But looking ahead, will the next big move in these stocks be higher or lower?

The case for additional gains…

Not surprisingly, some of the major oil stocks have seen short-term gains. For example, Shell’s stock price is up 17% over the past three months, with the period providing most of the 25% gains over the past year.

The fact that oil has reached well over $100 a barrel, hitting highs not seen since 2008, has boosted investor confidence in stocks related to this commodity. In theory, a higher oil price increases the revenues of the oil majors, which increases profitability. For companies with trading divisions (such as Glencore), higher volatility helps provide more opportunity.

Further gains for these major oil stocks could occur if the price of oil holds at current levels for some time. This allows companies to benefit from the oil price lock on futures contracts. For the next year or more, by setting the price high, these companies can take advantage of the high profit margins offered at current levels.

If the situation in Ukraine worsens and tougher oil sanctions are imposed on Russia, oil prices could rise further. Alternatively, if demand for oil continues to rise (eg via jet fuel), this could also put upward pressure on the price. Again, this would likely drive oil company stocks higher.

…and why major oil stocks might struggle

Given that oil has recently reached levels not seen in over a decade, the risk/reward balance worries me somewhat. If I was thinking of buying a stock with a rising price due to a product that is trading at the highest level in a decade, I would be inclined to wait for a pullback because it could be overvalued.

If we get the peace in Ukraine that we so desperately hope for and the sanctions are lifted, the price of oil will probably go down. Even if the major oil stocks manage to hedge and lock the price at high levels, the stocks could still fall in the short term. Speculative investors might sell hastily to look for a new opportunity.

Another point that could harm this sector is if specific sanctions disrupt the drilling, refining or marketing of oil. This has not been the case so far, but I cannot rule anything out in the future. Even without sanctions, some companies could experience difficulties due to the offloading of Russian-based assets. For example, BP’s sale of its stake in Rosneft was negative for the stock price.

While I think the oil price is currently overvalued, I don’t think major oil stocks are overvalued. I think companies can take advantage of the high price to enjoy it for the next year or more. And I think stock prices may well rise further. This should remain true even if oil prices decline during this period. That’s why I’m considering buying stocks in this sector now.

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Jon Smith and The Motley Fool UK have no position in any of the stocks mentioned. The opinions expressed on the companies mentioned in this article are those of the author and may therefore differ from the official recommendations we give in our subscription services such as Share Advisor, Hidden Winners and Pro. At The Motley Fool, we believe that considering a wide range of ideas makes us better investors.

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Steve R. Hansen