by   |   January 21, 2014   |   on ,

Sell Big Oil Stocks Now

If you haven’t noticed, individual stock-pickers are trouncing the market. Fueling their performance is a reliance on valuation.

Markets are bidding up undervalued stocks and selling off overvalued stocks. It is that simple.

Right in the middle of the overvalued category are big oil stocks. For the most part, big oil stocks are priced at multiples of earnings that far exceed profit growth expectations in the coming year.

Some of that premium is due to the large cash flows generated by these companies and the dividends they pay. When things go bad though, a rich valuation can result in a stock turning south in a hurry.

It’s not worth the risk. These big oil stocks should be sold, and sold posthaste.

Royal Dutch Shell (NYSE: RDS-A) shares fell on Friday after the company released a surprising profit warning.

Royal Dutch Shell announced a fourth-quarter profit of $2.2 billion, down from $7.3 billion. That decline was blamed on high maintenance expenses, deteriorating security in Nigeria and weak refining margins in Asia and Europe.

These should all be warning signs for all big fully integrated oil companies, but there were Shell-specific issues, too, that hurt the company’s performance, including a $700 million asset charge related to the Eagle Ford shale production in Texas.

Isn’t fracking going to change the oil world?

It is for the land owners in fracking-rich shale oil territory, but not so much the large oil companies.

Morgan Stanley (NYSE: MS) said Friday that it was selling off oil assets. While those moves are related to balance-sheet risk management with respect to commodity investments by large financial institutions, the liquidation of oil assets in particular should be troubling to owners of large oil stocks.

Like it or not, large financial firm speculation in the commodity markets had benefits to the entire sector — liquidity and pricing transparency, to name two. What happens to pricing now that these entities are selling?

Oil prices are already under pressure from increasing supplies and geopolitical stability. Take away the speculators and oil prices will fall further — and further than currently expected.

In a note to clients, Oswald Clint of Bernstein Research said that while surprised by the Shell news, the development appears to be company-specific rather than industry-wide.

I’m not so sure that’s the case, and I would not wait around to find out. My basis is valuation.

Look at Chevron (NYSE: CVX). Analysts expect the company to grow profits by a paltry 2% in 2014. If oil prices fall, that number could turn negative.

At current prices, Chevron trades for 10 times 2014 estimated earnings. With interest rates going up, the 3.3% dividend Chevron pays is not enough to make up for the risk of profits falling.

While Shell’s issues are indeed unique to Shell, other companies can have their own issues.

I would not take the risk with big oil stocks today. It’s just not worth it, and there are better opportunities elsewhere.