Five reasons to be bearish on oil stocks by Fortune Editors @FortuneMagazine June 15, 2011, 4:58 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons By Lou Gagliardi, Hedgeye We are now leaning more bearish on oil equities, mainly due to worsening macro factors. We’ve also turned bullish on the U.S. Dollar (USD) as the Fed’s second round of quantitative easing is ending and there’s little upside to the euro as the EU continues to socialize the periphery’s fiscal imbalances at every step. Of course, a strong USD is trouble for energy equities, at least in the immediate-term. There are five immediate risks to oil stocks. 1. Global growth is slowing. The latest employment data confirms what we’ve been harping on since the beginning of the year – jobless stagflation in the U.S. But it is not just the U.S. facing economic woes – the European Union is weighed down by the PIIGS, evidenced by the most recent PMI readings, and emerging markets are choking on commodity inflation. In short, global growth is slowing. That is bearish for equities generally, but for energy equities in particular, which rely heavily on oil and gas consumption. 2. We are bullish on the U.S. dollar. A stronger U.S. dollar lends to greater downside risk for oil equities, given the high inverse correlation between crude oil and the USD, running at -.90 YTD. This leaves energy equities, particularly high oil-weighted companies (like oil sands) exposed to greater downside risk. As the chart below demonstrates, when the U.S. Dollar draws near 2.0 standard deviations from its long-term average, its correction is sharp and the correlation risk to energy stocks is acute. Right now we are nearing that tipping point. 3. The supply-demand fundamentals for petroleum in the U.S. are weak. We have not seen improving trends in U.S. petroleum supply-demand picture of late, particularly for transportation fuels. Summer driving season may be challenging this year for motor fuel consumption, as the latest inventory report was decidedly bearish – crude oil and motor gasoline stocks built ahead of Memorial Day, rather than the typical drawdown. Furthermore, consumption (demand), as reported by Mastercard, continues to run at -2% year-over-year. Oil inventory is well-above last year’s level and the 5-year average. Likewise, gasoline inventories are building counter-cyclically as refiners chase stubbornly high cracking margins and consumption runs at -2% year-over-year. And refining margins are being “artificially” held up by WTI’s discount to other light, sweet crudes, and not by increased consumption; gasoline and crude inventories are building just as refining margins are declining. We are especially bearish on the U.S. refining industry right now. 4. Sentiment on oil is too bullish. WTI crude oil has slipped below $100/bbl and we think one of the main reasons was that consensus was too long the commodity. We think that investors are still too bullish on oil, with the spread between long and short futures contracts 3 standard deviations above the 20-year mean (see below chart). Our call on oil is that it touches $88.00/bbl this summer. 5. Energy companies will see margin compression in the second and third quarters. We continue to see mounting cost pressures across the energy sector that we believe will narrow margins in the next two quarters of 2011, particularly as crude prices in the $90 to $100/bbl range may not provide much support if demand remains weak. By-and-large margins tightened in Q1 – we expect that to accelerate. Better buying opportunities lie ahead. We see too many headwinds in the immediate-term for oil equities, the strongest of which being the weak macro environment and our bullish call on the USD. Over the longer duration, we are still bullish on oil and oil-weighted companies, like the oil sands SU , though we see it increasingly difficult for their shares to move higher in the short-term.