If first-quarter 2011 was good for oil and gas stocks in both absolute and relative terms (S&P 500 Energy up 16%; S&P 500 up 5%) then the second quarter was bad (S&P 500 Energy down 5%; S&P 500 flat) and the third quarter even worse (S&P 500 Energy down 21%; S&P 500 down 14%).

Not only have energy equities lagged stocks of other sectors, they have also paced oil prices downward, especially in the third quarter, when front-month Nymex crude fell only 9% as compared to the 26% decline in the S&P 500 Oil & Gas Exploration Index (which reflects the subsector with earnings capacity most directly linked to commodity prices). Is the sell-off in energy stocks exaggerated, in which case the outlook for the last quarter of 2011 should improve, or do oil prices face further downside risk, in which case the outlook is uglier still?

Even though energy has underperformed the broader equity markets, conversations with energy investors indicate that they sold en masse based on fears of macro-level risks rather than concerns about industry or company-specific fundamentals.

Amid mounting expectations that the U.S. and Europe would enter a recession in the fourth quarter, short-term traders reduced leverage and long-only fund managers underweighted their portfolios relative to their benchmark indices.

Accordingly, there was no differentiation in the performances of energy companies with stronger balance sheets or better growth potential. Higher beta sub-sectors, such as drillers, oil services and refiners, saw the steepest losses in the third quarter, with their associated S&P 500 indices falling 32%, 32% and 30% respectively, while comparatively safer integrateds fared better, with the associated S&P 500 index declining only 14%.

In contrast to equities, oil prices remained relatively strong, though West Texas Intermediate (WTI) and Brent experienced different dynamics. Despite faltering economic growth in most OECD (Organization for Economic Cooperation and Development) countries, Brent has held up, due to the loss of light sweet crude from Libya and production issues in the North Sea. Yet Brent is in a state of steep backwardation—the further ahead on the futures curve, the cheaper prices become—suggesting that the market is expecting a more tepid pace of growth in non-OECD economies.

Meanwhile, near-term WTI prices have been pressured by temporary supply bottlenecks at the Cushing storage hub. However, even as Cushing inventories have dropped by more than 10 million barrels since May, the futures contracts have moved to a deeper state of contango—the further ahead on the curve, the higher the price—leaving one to question whether the contango in WTI merely reflects logistical issues in the Midwest or, more critically, a weaker near-term outlook for the U.S. economy. As WTI and Brent prices have decoupled, they also, similar to recent equity performance, provide limited read-through into global fundamentals.

Irrelevant valuations?

Given the underperformance of energy equities relative to oil prices, valuations are arguably compelling, but have become irrelevant, at least temporarily. The CBOE Market Volatility Index, or VIX, which surged 160% in the third quarter, drove equity risk premiums higher for stocks across the board. According to Bank of America Merrill Lynch, the VIX surge translated into a 10% to 30% increase in the weighted average costs of capital for energy stocks.

So, while U.S. oil stocks underperformed in the third quarter, their more capital-intensive Canadian oil-sands counterparts fared worse, even as light-heavy oil spreads narrowed. With the State Department expected to approve TransCanada’s Keystone XL pipeline for transport of Canadian crude to the Gulf Coast by year-end, and with front-month WTI ending the third quarter at a low price of $79.20, oil-sands stocks have received more attention as the market questions the economics of these projects (while environmentalists pose a different set of issues).

Mining projects are of particular concern as they have higher capital requirements to reach peak oil rates, with an average estimate at $90 per barrel for breakeven, while steam assisted gravity drainage (SAGD) projects are thought to be economic at approximately $60 per barrel.

However, even if oil-sands production is profitable at a minimum of $60, once investments are already made in fixed capital, the marginal cost of production is lower. And unlike conventional oil fields, where operators must continue to invest significant dollars to replace declining production, SAGD wells ramp up over time and then stabilize with little capital required to maintain flat production.

Canadian oil sands are expected to become the U.S.’ largest source of imported oil this year, surpassing conventional Canadian oil imports and roughly equaling the imports from Saudi Arabia and Kuwait combined. As an interesting aside, natural gas is a significant fuel in oil-sands production. Demand for natural gas from current oil-sands output is estimated at about 0.9 billion cubic feet per day, and this figure can move substantially higher if projects planned to be onstream by 2015 are factored in.

While the expansion of oil-sands production might thus provide a base level of incremental demand for natural gas, it could also pressure U.S. oil prices, especially Light Louisiana Sweet (LLS). As Keystone XL and other planned pipelines transport increasing volumes of oil to Gulf-based refineries, the equity performance of U.S. oil producers in the fourth quarter and beyond could face more headwinds.