Drilling for Profits

Published in Buyside

Analysts See Oil Industry as Safe Haven for Investments

Sales of gas-glugging SUVs outpace most other vehicles.  The eastern U.S. shivers in the grip of one of the coldest winters in recent memory. War with Iraq grows more likely every day.

These seemingly disparate facts of American daily life all have one thing in common: They are all positive signs for investors in the oil and natural gas industries. Experts say investors haven’t yet warmed to the notion of investing in the oil and gas sector, even though the outlook is encouraging.

Companies ranging from the international “super majors” whose operations cover the entire spectrum from searching for new oilfields to filling an automobile’s gas tank to the independent firms with specialty niches like seismic data analysis that are both profitable and undervalued — still a rare combination in today’s markets.
A Simple Case of Supply and Demand
A basic tenet of business is that when supply can’t keep up with demand, prices rise. Despite the recession, the U.S. is using more oil and natural gas than is being produced and imported.

Other short-term factors, such as the prospect of war in the Middle East, unusually cold weather and the recently resolved oil workers’ strike in Venezuela all tend to push prices temporarily higher than they would otherwise be. But the long-term trend suggests prices will continue to rise, at least for a while. These factors will influence the speed at which oil and gas prices rise, or the timing of the peaks and valleys, but the trend is still modestly upward.

U.S. oil inventories are about nine percent below what they were a year ago, and January oil inventories were the lowest in 25 years, analysts say.
And due to the harsh winter, inventories of U.S. natural gas have fallen below five-year average levels, according to the U.S. Energy Information Administration’s storage level survey. Natural gas appears to pose a widening gap between demand and supply.

Despite prices running 50% higher than last year, natural gas production in the U.S. has actually declined by five or six percent, says A.G. Edwards & Sons Oil and Gas Analyst Bruce Lanni.

Demand for oil increases by about 1.5% annually, says Tina Vital, energy analyst at Standard & Poor’s Equity Group in New York. “Demand for natural gas will rise about two percent from all end users, but supply should drop about 1.5%. So we’ve got 3.5% to make up, and we think that will drive prices up,” Vital says, quoting projections from Global Insights.

In spite of that shortfall, natural gas exploration and drilling in the U.S. is only just beginning to increase.

The “Super Majors” as Safe Havens
The wave of consolidation among international energy companies during the past decade has created a class of companies analysts refer to as “super majors” or “the large integrateds.”The nicknames are shorthand for those huge companies that are active in a broad spectrum of energy businesses. Think Exxon Mobil Corp. (XOM) or ConocoPhillips (COP).

These companies have become so broadly diversified that they are no longer as cyclical as smaller businesses whose fortunes rise and fall in tandem with the price of a barrel of crude oil.

“Over a 20- to 30-year period, their earnings have not been very cyclical.  They’ve risen at a nice, steady clip, a nice upward flow, regardless of what the economies have done, regardless of what oil and gas prices have done,” Vital says.

Operations in nearly all parts of the industry, spread out across the globe, help the major firms to mitigate political risk, economic concerns, or supply issues. “That indicates to me that they’re safe havens over the long term.”

And unlike their trendier technology stock counterparts, the big oil firms pay dividends, further improving returns for investors, Vital points out.

Often, investors view oil companies as risky, speculative investments. And to be sure, there are wildcat drillers and mom-and-pop operations whose entire fortunes rest on whether a single exploratory venture pays off.

But the major international firms are actually very conservative today. Following those big mergers, many have streamlined operations, become more efficient, and cleaned up their balance sheets. The super majors as a group have just 18% net debt to equity, according to Standard & Poor’s.

“While you may not see very high growth rates, you tend to see preservation of capital. It’s a nice cornerstone investment,” Vital says. “It may not be as exciting as some tech investments, but it’s steadily improving over time, and that’s something to be said in this environment.”

While the S&P 1500 declined 22% in 2002, the oil sector slipped just 14.5%. Victory Capital Management Oil and Gas Analyst Bill Chapman also likes the major oil firms, and views their diversification as a hedge against lower oil prices. “We’ve been building up our weight in some of the more diversified companies, when you see a drop in the price of oil, you’ll see some benefits on the other side through a better refining and marketing process,” he says.

Victory has a bit more of its $22 billion in equity investments than the S&P index’s roughly six percent. The company expects oil and natural gas prices to fall, so it has shifted its focus away from exploration and production companies, believing them to be more vulnerable to falling prices, according to Victory’s Portfolio Manager Neil Kilbane.

The big mergers have run their course, says A.G. Edward’s Lanni. He thinks the benefits of huge oil industry mergers diminish with each additional deal.

Where Gas and Oil Don’t Mix
While oil and natural gas are often viewed as disparate parts of the same industry, the relationship is changing. Oil is very much an international business; crude is extracted all over the world, then shipped to anywhere it commands the best price.

The logistics are not quite so simple for natural gas. Natural gas used in the U.S. must be produced in North America. With the technologies in place today, there is simply no cost-effective way to ship it half way around the world.  While demand has increased, and U.S. inventories are very low, drilling activity is only just starting to pick up. Most of the analysts Buyside interviewed think natural gas drilling activity will increase later in the year.

“The problem in the U.S. is that we have very old natural resources, and you can only squeeze so much juice out of an orange, so imports are becoming increasingly more important,” Lanni says. “Prices, as a result, will probably stay higher than they have historically.”

For years, a widely used formula suggested that natural gas prices were firmly linked to the price of a barrel of oil.“The price of natural gas vis-à-vis the price of oil is probably a little bit richer today than it has been historically, and I think there are reasons for that,” Chapman says. “We’re short in our ability to provide natural gas incrementally, so I think the price of natural gas is going to be better. But I think it’s still vulnerable to the downside when the price of oil falls.”

One reason investors like natural gas is that some 90% of new electricity generating capacity is fueled by natural gas, says Joe Dancy, manager of LSGI Fund Advisors. “It’s cleaner than coal and doesn’t have the same environmental issues as nuclear.”

That suggests demand is likely to continue. Natural gas prices, at around $5 per million BTUs (British Thermal Units), are 50% higher than they were a year ago. While that price will likely decline as the heating season ends, it is still high enough to justify drilling new wells, at least by smaller E&P firms.

Global Insight projects an average natural gas price of $4.42 this year, dropping to $3.50 next year. “We think people are going to have to start spending on drilling even if demand hasn’t picked up. Otherwise, we could be setting ourselves up for quite a good price spike in natural gas,” says Vital. “We think North American natural gas drilling activity will rise about 15% this year.”

The integrated oil firms are more focused on international gas reserves and “stranded” fields, which hold gas that has not been economically feasible to produce at lower gas levels.

As production in the U.S. and Canada declines, liquefied natural gas (LNG) imported from those locations will become a larger part of U.S. gas consumption.

Follow the Reserves
Analysts agree that a key factor in choosing a company to invest in is how successful it is at increasing its oil and natural gas reserves and growing production from year to year. Vital likes the French integrated firm TOTAL FINA ELF (TOT) because it has a very high reserve replacement rate, and has steadily grown its production. “TOTAL FINA ELF is a good buy because it’s a relative newcomer to the super major field,” she says.

“The stock trades at a discount to the other super majors, yet it offers a very high ROI and return on production growth.” Exxon Mobil has demonstrated a consistent production growth rate of two to three percent, and that’s why Vital is recommending it as well. “While you might see the market reward Exxon with a slightly higher premium in the market, they’re being rewarded for their earnings stability,” Vital says.

Victory Capital Management has increased its position in BP (BP) and ConocoPhillips. “They have the diversity of operations so if the price of oil and gas goes down, there’s a bit of a cushion in the refining and marketing areas,” says Chambers.“We also like those companies because they’re selling at relatively modest multiples to what they’ve sold at in the past.”

Ellen Hannan, oil and gas analyst at Bear, Stearns & Co., recommends watching the fundamentals. She likes to see good management and a strong balance sheet. She also watches free cash flow very carefully.

Modern Prospectors
Companies that search out and drill oil and natural gas wells are known as exploration and production (E&P) companies, and the experts see some attractive plays in this arena, too. Victory has positions in several E&P companies, according to Kilbane. The fund’s approach is to “buy good companies particularly if they are positioned for substantial success in their drilling programs,” Kilbane says. Here, too, a company’s ability to replace reserves and grow production is key.

Kilbane likes Kerr-McGee Corp. (KMG) and Unocal Corp. (UCL). Kerr-McGee is one of the largest leaseholders in the deep Gulf of Mexico.“They’ve got very active drilling programs, and we think the possibility of success is great relative to the [other E&P firms],” he says.

Chambers likes Unocal’s international operations.“They have some interesting discoveries and a lot of shelf positions where they can go down to the deep depth and look for incremental natural gas deposits that look interesting.

Nabors Industries (NBR) reported a 10% increase in drilling activity in December, says Vital. S&P is recommending Nabors in this sector.

Hannan expects volatility to continue in the E&P sector, and she recommends looking for companies prepared to weather a volatile environment. Her top pick in the sector is Apache Corp. (APA), a choice echoed by others. Hannan likes Apache for its ability to make well-timed acquisitions of potentially profitable reserves. One of the largest E&P firms, Apache is drilling in Texas, Oklahoma, Canada, Australia and Egypt, where it recently announced its fourth consecutive discovery in deep offshore waters. Apache also recently acquired some promising leases in the Gulf of Mexico shelf region from BP.

Oilfield Services and Technology
One of the ways the super major oil firms cleaned up their balance sheets was to outsource some services to niche firms that specialize in them. Increased drilling activity and rebuilding efforts following and conflict that might occur could keep those firms busy. From companies that apply the latest technology to pinpointing pockets of oil and gas to those that deliver basic support services, there are attractive candidates here, the experts say.

Dancy points to a couple of firms that provide compressors — the electric motors used to keep drilling rigs and wells running — as good microcap candidates. In particular, he likes Natural Gas Services Group (NGS), a $20 million company that rents or sells compressors and posted a 23% increase in its business last year. Dancy picked it as his “2003 Investment Idea of the Year” by the Dick Davis Digest. Wellhead compressors help drillers get more gas out of their wells, Dancy says.

The Iraq Factor
Concerns about the impact of a war with Iraq may have driven some investors away from the oil and gas industry.

Predicting future oil prices is tricky business, the analysts agree, but there are a few models to consider. How long might a conflict last? Will neighboring oil-producing countries be affected? Will OPEC fill the gap caused by a loss in production? How long might it take for production to resume in Iraq? And what happens to Iraq’s oil fields once the conflict ends?

Some analysts think current oil and gas prices already reflect concerns about a war and Saddam Hussein’s threat to set fire to Iraq’s oil fields, as he did to Kuwait’s oil fields in 1995. Two situations — the Gulf War and the recent labor shutdown in Venezuela — may offer some hints as to the likely outcome.

Prior to the strike, Venezuela produced about 1.5 million barrels of oil per day (bpd) — roughly the same as Iraq’s production. OPEC agreed to increase production to cover some of that loss, and would likely do so if Iraqi production shuts down, as most expect it will if the U.S. attacks Iraq.

OPEC has said it could probably not replace the combined three million bpd of the two countries’ combined production, Vital says.

A further shortfall could, of course, lead to higher prices. “If Persian Gulf exports were disrupted, then I think that would send oil prices spiraling,” she says, adding that S&P does not expect that to happen. Even if Iraq’s oil fields are severely damaged, one expert says Kuwait’s wells were repaired and production resumed in just a few months after the Gulf War ended, far less than the years some thought it would take.

There are both positive and negative impacts once the conflict ends. Iraq’s drilling equipment and technology is outdated; getting its oilfields up and running again could be a boon for oilfield services companies experienced in such international operations, like Schlumberger (SLB), says Chambers. “The stock is selling at a really attractive price right now. When I look at price-to-cash flow, I see Schlumberger selling not much different than the [overall] market’s priceto-cash flow. I take that as a benchmark of when a stock is attractive.”

The potential longer-term downside is that once Iraq’s oil fields are repaired, production could be increased to help pay for the country’s reconstruction efforts, thus pushing oil prices down.

Even so, A.G. Edwards’ Lanni doesn’t think oil prices will fall as far as some have suggested. Even with Venezuela and Iraq producing oil at or near capacity, “Prices may come down, but not to that sub-$20 level that the bear community has been preaching,” Lanni says.“There’s nothing to suggest that they should even come close to that. We may even see prices fall back to the mid-$20s, that’s where we think there’s a comfortable price.”

A Good Time to Buy?
The lack of attention focused on the oil and gas industry and its subsectors could be good news for investors.

Even though the industry appears poised to do well over the next couple of years, stocks are trading at substantial discounts to historical averages.  The integrated oil companies are trading at prices that are “reflecting a $19 to $20 oil price and I think it should be $22, so they’re selling at roughly a 10% to 20% discount to the market, Lanni says.

There appear to be solid opportunities ranging from the largest international oil companies all the way to the niche suppliers of technology and support services.

As a group, analysts were most bullish on the large integrated firms, “We’ve got large market cap stocks, [with] high liquidity, high dividends, strong balance sheets, modest growth, clear earnings visibility — which you cannot say for a lot of sectors in the market today,” Lanni says, “the possibility of upward earnings revisions … and the strong generation of free cash flow which can be used to buy back stock, raise dividends or make acquisitions. Do I think that the integrated oil group is ripe for the picking? Absolutely!”


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