Unearth Rational Profits in the Oil Patch

With respect to investing,rational investorscan usehuman behavior toidentify market inefficiency.There are numerous instanceswhen human behavior leads to irrationalexuberance through too much buyingor fearful selling. In either case, the endresult is a buy or sell opportunity thatcan be exploited for future profits.

Bubbly Investments

One of the consequences of the bearmarket and technology bubble crashhas been the human instinct to declareany asset class appreciation to be unsustainable.That behavior manifested itselfin the housing bubble of 2002. Threeyears later we are all still waiting for thismarket to burst in a blaze of disaster.Home prices and home building stockshave doubled or tripled in value duringthat time. Ignoring valuations andgrowth prospects, the majority of marketparticipants reacted to rising homeprices as a signal of the next bubble thatwill burst. The fear in the market wassuch that any kind of appreciation wasmet with extreme skepticism, and thatreluctance to buy created discounts forrational buyers of homebuilding stocks.

Today we are faced with an oil marketthat has seen impressive gains overthe last 24 months. That appreciationin turn has resulted in a similar cry thatthe market for oil is a bubble waitingto collapse. The bubble camp is of theopinion that much of the rise in oilprices was due to speculators with littleinfluence from true supply anddemand for the commodity. There hasbeen an influx of speculation frominstitutions hungry for momentum andreturns, but the lion's share of the gainin oil has correlated directly with economicgrowth over the past 2 years.

Demand in the United States andChina continues to grow at impressiveclips. With minimal sources of newsupply, the market for oil has nowhereto go but up. Even if growth slows asexpected, oil prices should continue totrade at the high end of the recentrange. Only a recession will break thetrend, but as evidenced by the FederalReserve's willingness to raise rates, arecession seems unlikely.

Oily Future

The Rational Investor

So what should physician-investorsdo under these circumstances? We atcan peruse theentire oil sector given the state of theunderlying commodity and find manyintriguing possibilities. In the refinerysector for example, many companiestrade for single-digit multiples to currentand forward earnings. With earningsexpected to continue growing andanalyst expectations low, the disconnectbetween current valuations and futureprospects is large. We would look atowning stocks in the sector at today'sprices. Tesoro Petroleum (TSO) andGiant Industries (GI) are two of ourfavorites in the oil sector.

In the oil shipping sector, the sameparameters are in play. Valuations arereflective of future conditions that areexpected to be less than spectacular. Wethink that a drop in shipping rates ispremature. Shares of oil shippers OMICorp. (OMM) and Frontline Ltd.(FRO) trade for single-digit multiplesof forward earnings. We expect performanceto exceed expectations here,making the sector one of our favoriterational plays of the current year.

Keep in mind the quick call to an endof a speculative bubble creates opportunityfor rational investors. The homebuildingsector was quite profitable inthe 3 years after calls for its demise. Thesimilarities to the oil sector are striking.As a result, tomorrow's profits may verywell be in the oil patch.

is editor of The Rational

Investor newsletter. He has worked in

investment banking and financial services,

including personal money management and

as vice president of a regional brokerage

firm. He holds a master's degree in business administration

from the University of North Carolina. He welcomes

questions or comments at 612-332-0249 or jdlugosch@therationalinvestor.com. For more information, visit

www.therationalinvestor.com.

Jamie Dlugosch