Commodities Corner: Bullish on Oil

July 9, 2006

Persistently high oil prices have helped drive up shares of Oil companies steadily for two years now. Will the run continue? What companies are best positioned for future gains?

Crude oil prices have remained perched atop the 70 dollar per barrel level for over two months now, even topping 75 dollars last week, setting new all-time highs.  Geopolitical concerns about North Korea’s missile launches, Iran’s nuclear enrichment program, attacks on Nigerian oil fields, and increasing global demand have all contributed to the surge in the commodity.  Although all signs point to solid prospects for the industry, shares of major oil producers and refiners have suffered significant declines across the board, only recently making up some lost ground.  The severely undervalued sector has great potential for a continued run.

Last month, Citigroup raised its oil price forecasts for the years 2006-2009, acknowledging the likelihood of oil prices remaining at high levels.  However, their model predicts oil prices steadily dropping down to the 50 dollar a barrel level in 2009.  The current price of oil includes a fear premium for geopolitical events, but even if those conflicts were to be resolved, the issue of rising demand remains.

Emerging economies like India and China are experiencing rapid growth which requires resources like oil and building materials.  At home, Americans have continued to steadily consume gasoline at prices over $3 a gallon.  The average American is estimated to consume about 7,500 gallons of oil per year and shows no signs of slowing down.

Strong fundamentals for oil stocks make them very attractive investments.  Many companies are trading at P/E ratios of under 10, half the average valuation of the S&P 500.  Future earning expectations for these companies may also be lower than actual results due to the anticipation that oil prices will decline.  With demand for oil on the rise, oil companies should continue to post record earnings results.

Recently, the oil sector has pulled back in line with the broader market.  Exposure to energy stocks should be part of every investors core portfolio, since it can also act as a hedge when geopolitical events or hurricanes strike, sending down stocks in other sectors.  The risks to oil stocks remain lower than other stocks because their strong fundamentals and cash balances which make them attractive takeover targets after any decline.
           
Anadarko Petroleum announced on June 23rd that it would pay $21 billion to acquire smaller rivals Kerr-McGee and Western Gas Resources.  Consolidation in the sector is ongoing, and more deals can be expected.

Choosing stocks within the sector can be tricky.  Some companies have overweighted themselves in natural gas, while others focus primarily on refining or oil extraction.  The valuation of the company can also vary from several thousand to almost 400 million dollars.  One of the leaders of natural gas procurement is Apache (APA), although the stock hasn’t moved much recently.  For refining plays, Valero (VLO) and Sunoco (SUN) have exciting prospects.  Valero operates the most refineries in America and is able to benefit from its ability to refine lower quality crude oil’s, resulting in a larger share of profits.  Sunoco is a smaller company that is still growing and expanding its operations.

Another strong pick is Occidental Petroleum Corp (OXY), despite having its operations in Ecuador seized by the foreign government due to a contract dispute.  Occidental trades at a P/E of just 7.5, and a $44 billion market cap gives it room to grow.  Like many other oil companies, Occidental pays a quarterly dividend of 36 cents, yielding 1.40% per year.  Larger entities like Exxon (XOM) and Chevron (CVX) exist, but their enormous size makes it difficult for them to grow.

Most Americans, along with much of the world, have come to terms with the fact that oil and gas prices will inevitably remain high.  Wall Street has not acknowledged this yet, leaving many oil companies severely undervalued.  Until the value of oil stocks is realized, fill up your portfolio with the prodigious commodity.

At the time of publication, Dhinesh Ganapathiappan did not own or control shares of any companies mentioned in this article.