Energy Stocks Waiting On Economic Developments

Tomorrow morning we will get the first preliminary estimate for U.S. gross domestic product (GDP) for the first quarter.  Estimates from economists on and off Wall Street suggest the quarter will reflect significant negative growth, but the question is whether it will be better or worse than the fourth quarter of 2008's decline of 6.3%.  Estimates for the quarter we have seen range from -4.2% to -8.0%.  Not only is this range very wide, but the ends of its convey significantly different views of the health (or rate of deterioration) of the economy and its timing for recovery.

Since everyone expects the announcement to be negative, the issue for investors is which end of the range of negative estimates is baked into current stock market prices.  We tend to think that the Street is expecting a number somewhere around negative 5%.  If the reported estimate (which is subject to several revisions over time) is less than a 5% decline, stocks will likely spike up and energy stocks should fare better as investors will perceive the economic recovery is coming sooner.  On the other hand, if the number matches or exceeds the fourth quarter decline, stocks will likely slump with energy markets coming under pressure due to expectations of a longer recession before the economic recovery emerges.  The greater risk on the negative side is that crude oil and natural gas prices come under increased pressure since inventories of both commodites are at record levels and, faced with a delayed economic recovery, at risk of a sharp fall as investors lose hope that increased demand will hold prices or lift them higher anytime soon.

Since the beginning of the year, energy stocks have underperformed the overall stock market by about 7%.  the underperformance has gotten worse in recent weeks as the market has staged a strong rally.  We have not been surprised by the underperformance as we felt that the December lows for energy stocks had overdone the expected decline in earnings in 2009 and 2010.  Energy stocks rallied along with the overall stock market in the early part of the year as oil and gas prices rose.  Now energy stocks are working through the earnings revision phase of a broadbased industry downturn, but we haven't finished it yet.  A key to whether the stocks will begin to outperform the market is when a calalyst emerges that encourages investors to begin boosting company earnings expectations.  Whether that means higher commodity prices from stronger global energy demand or from a significantly weaker dollar remains to be seen. 

We would suggest that investors pay attention to the growing saga of Bank of America.  If it turns out that CEO Ken Lewis is correct that he was pressured by the former Treasury Secretary and the head of the Fed to go through with the Merrill Lynch merger and not to disclose the financial deterioration, we could be faced with a forced leadership change at the Fed.  Consider the impact that scenario would have internationally on the value of the dollar, and by implication, commodity prices, especially oil prices.  Whether this scenario occurs is impossible to forecast, but there is some odds it might.  Could this be the Black Swan that hurts the economic recovery pace, the stock market rise and energy prices?