E Why Oil Can’t Provide ‘Deep Value’

With oil trading at the lowest prices in a generation, an increasing number of commentators are beginning to describe the commodity as one that offers ‘deep value’.

While oil is certainly trading at a deep discount to its long term average price, and may very well regress back towards this average with higher prices, there is simply no way that it can accurately be described as offering deep value in the traditional sense of this phrase. Let’s take a look at what happens when we try to apply the conceptual framework of deep value to oil and other natural resources.

Understanding Deep Value

Deep value is a methodology of buying something for less than its actual, intrinsic worth. When applied to shares in a company’s stock, this ultimately means that if the company were to be liquidated its net asset value and the proceeds divided among its shareholders, they would each receive more than the current share price. A pricing inefficiency has caused shares on the open market to take on a value that is lower than the intrinsic value of the company’s stock.

When we try and apply this concept to crude oil, we immediately run into insurmountable problems. Oil does not appear to have an intrinsic value. Its value at any given time is determined entirely by the open market, which is to say the balance of supply and demand.

This can be hard to appreciate because all developed and developing economies need oil, and lots of it. In that sense oil certainly seems like it should be more universally valuable than, say, the shares of a small pharmaceuticals firm manufacturing a handful of specialist drugs.

The crucial difference here is that a stock is actually just a ‘wrapper’ for a diverse bundle of both tangible and strictly notional assets and liabilities: prospective dividend yields, earnings, liabilities, real estate holdings, trademarks, patents, goodwill. . . Some of these assets may have a known liquidation value that can be substantially greater than the price at which the ‘wrapper’ can be acquired on the open market. This temporary dislocation between the market price and reality is what value investors are looking for.