Jubak's Journal
It's time to buy oil stocks, not sell them
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Even if crude prices have peaked, the realities of today’s energy markets are bigger than OPEC and its quotas. Here's why.
By Jim Jubak
Wall Street loves a consensus. It’s smitten with the notion that it’s time to dump oil stocks because the price of oil may be headed back below $40 and will likely wind up below $30 by the end of the year.
That’s why the share prices of ChevronTexaco (CVX, news, msgs) fell 3.3% in the week that ended May 21, why Shell Transport and Trading (SC, news, msgs) was down nearly 2% in the same period, and why BP (BP, news, msgs) dropped nearly 2.7%. Those declines don’t seem like much until you note that they’re about four times or more the size of the 0.46% drop in the Dow Jones Industrial Average ($INDU) during what was a bad week for that index. It’s all downhill from here, right?
Wrong, wrong, wrong and wrong.
A 1% or 2% drop isn’t much of a buying opportunity, but I think this is the time to be buying more shares of oil producers and refiners rather than selling the ones you have. Specifically, I’ll be looking to add shares of ChevronTexaco after OPEC meets on June 3. The stock market is expecting an announcement that OPEC will boost production, and I think that announcement could dent oil stocks in the very short term.
But the stock market is dead wrong about the power of the Saudis or any other oil producer to move prices much below $40 before the end of the summer. And investors are dead wrong who believe that a decline to $35 by the end of 2004 would hurt oil company earnings. At $35 a 42-gallon barrel, the oil companies would bury the current Wall Street consensus on oil industry earnings under a pile of profits.
Skeptical? I don’t blame you, but I think I can make a convincing argument why oil prices are going to stay higher -- and for longer than the market expects. I can also make a strong argument that, even at $35 a barrel, companies can crank out stronger-than-projected profits.
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Supply and demand drive prices
Supply and demand, not terrorist threats, is driving oil prices now. This is clearly the case for crude from Iraq. Unrest and terrorist attacks have cut oil production to 1.95 million barrels a day and Iraqi exports (since not all oil produced in Iraq is exported) to 870,000 barrels a day. That’s 23% below peak production and 56% below peak export levels. Iraq oil exports are back to levels last seen in September 2003.
There’s also an unexplained crimp in the pipeline from Russia’s Black Sea oil ports. Volumes at Novorossiysk, which handles about a third of all Russia’s oil exports, have tumbled to 1 million barrels a day in May from 1.5 million barrels a day in April.
Worldwide, oil supplies have fallen by about 1.5 million barrels a day in the last few weeks.
All the while, global demand for oil has been climbing. According to the International Energy Agency’s report for April, global demand for oil is now running at 80.6 million barrels a day. That’s up 330,000 barrels from the agency’s last monthly forecast and 2 million barrels a day higher than in 2003. And we’re just now about to hit the peak summer driving season in the United States. U.S. gasoline demand is up about 4% from last year and is projected to reach a record this summer of more than 9.4 million barrels a day.
None of this means that the world is about to run out of oil. World oil production still exceeds demand, and OPEC and the rest of the oil-producing countries in the world do have the ability to increase production.
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But supply right now exceeds demand by only a very small margin. To boost oil production, the world’s oil producers will have to run at better than 90% of capacity. That’s bullish for prices. In the past, according to an analysis by Sanford C. Bernstein, that combination of tight excess capacity and production at 90% or better of capacity has led to oil prices moving above $40 a barrel and staying there.
Historically, OPEC oil capacity has exceeded oil production by an average of 4 million to 5 million barrels a day. That, argues Bernstein, has meant that it took a major disruption in production such as the Iraq-Iran war or the Iraqi invasion of Kuwait to send oil prices spiking higher. The 1990 invasion of Kuwait, for example, reduced OPEC capacity to just 1 million barrels a day over production.
And, historically, whenever OPEC has operated at 90% of capacity or higher, oil prices have spiked to the $35 to $40 levels, Bernstein concludes.
It’s not all Iraq’s fault
This time, however, the capacity crunch isn’t simply a result of a geopolitical event shutting down a part of the world’s oil supply. Certainly, problems in the Iraqi oil fields don’t help. This time, however, the capacity squeeze is also a result of big increases in global demand. Thanks to that increased demand, by the time that normal exports from Iraq and Russia resume, global demand will have increased enough so that capacity still won’t regain its normal historical breathing room over production.
Take a look at two of the world’s biggest markets for imported oil, the United States and China. The Energy Information Agency of the U.S. Department of Energy is now projecting that the United States would have to import an average of 10.4 million barrels a day for the entire summer for refiners to avoid drawing down already slim inventories. That level of imports would be just about 400,000 barrels a day above the 10 million barrels a day the United States has imported on average over the last four weeks. (It is also roughly equal to the recent Russian oil export shortfall.)
This surge in U.S. import demand isn’t likely to disappear quickly. U.S. refineries usually build inventories in the spring to prepare for the summer surge in gas consumption. Inventories, however, have been falling rather than climbing lately, and, for months to come, refineries will be playing catch-up by buying more oil to replenish inventories.
China’s net oil imports climbed 41% year over year for January through April, but that’s not the end of the story. Because of higher prices and the possibility of shortages, China has begun to build its own emergency oil reserve. That’s had the effect of raising global oil demand and boosting oil prices.
The Chinese, who now import about 6 million barrels of oil a day, aren’t alone in this. India, South Korea and Taiwan are also building strategic oil reserves. According to Barclays Capital, reserve building by these four countries alone could amount to 215 million barrels of oil over the next two years.
That doesn’t mean that oil prices will stay over $40 a barrel into 2005. In fact, I think oil prices should come down this fall. Increased oil production from Saudi Arabia will start to hit the U.S. energy market later this summer. Much of that additional oil will be heavier grades that cost more to refine into gasoline. So, the additional supplies won’t help much as long as world demand is slanted toward the lighter gasoline grades preferred by refineries in the summer. But starting in the fall, when demand shifts back to heavier heating oil grades, I’d expect the extra Saudi production to make a difference.
Oil company profits will still be huge
While I see oil prices coming down, I don’t expect oil stocks to tumble. That’s because most Wall Street analysts are still building their earnings projections for 2004 on average oil prices for the year below $30 a barrel. Even if oil prices decline from current peaks, they aren’t likely to get as low as Wall Street now expects. So, oil stocks are likely to climb as oil analysts raise their estimates to catch up with the likely price of oil. (I wrote about the conservative methodology Wall Street analysts and corporate CEOs use to project oil prices and oil stocks in my April 2 column, “5 big-picture reasons to snap up energy stocks.”)
It’s going on even now. On May 14, Morgan Stanley raised its projections for the average 2004 price of a barrel of oil to $33 from an earlier $28 a barrel. On the new projections, Morgan Stanley figures that oil stocks are about 16% undervalued.
Merrill Lynch raised its own estimates for oil prices on May 20. The investment house now projects crude oil will average $31.60 a barrel for 2004, up from $30 before. For the second quarter, that’s the current quarter, mind you, the estimate climbed to $35 from $29.
Those projections are still likely to be low. Morgan Stanley is projecting that the price of crude will average $35 this quarter before falling to $33 a barrel in the third quarter. The investment house sees crude finishing the year at $30 a barrel. Even with its increases, Merrill Lynch is still calling for $28-a-barrel oil in the second half of 2004.
But these calls are still out in front of the Wall Street consensus. Merrill Lynch calculates that even after its recent price adjustments, projections for 2004 are about 7% above the Wall Street consensus.
If you increase the projected price of a barrel of oil, that should result in a huge increase in oil company earnings projections. Sure enough, on May 19, Commerzbank Securities raised its projections for oil prices in 2004 to $32 a barrel from $28. The new estimate, in turn, led the investment bank to raise its earnings projections for oil companies by 18% for 2004, by 15% for 2005 and by 20% for 2006.
The stock market now seems to believe that OPEC will announce increased production at its June 3 meeting. The additional production, investors think, will drive down the price of oil from current highs. In the very, very, short run, I think that’s possible, and any temporary dip in the price of oil is likely to take a temporary bite out of oil stock prices.
The long-term story is very different. Oil prices are likely to stay higher than Wall Street now expects for longer than now projected. And I plan to use any weakness in oil stocks on news out of the June 3 OPEC meeting to buy oil shares.
New developments on past columns
A safer way to play higher oil prices
With the Organization of Petroleum Exporting Countries set to discuss raising oil production on June 3, Saudi Arabia has begun asking ship brokers to line up oil tankers to handle the extra volume. Saudi Arabia, the only OPEC member with the ability to significantly increase production, has said that OPEC should increase production quotas by about 8.5%, or 2 million barrels a day, from the current 23.5 million barrels-a-day limit.
Spot rates for two categories of tankers used on routes between the United States and the Middle East -- Very Large Crude Carriers (VLCC -- 200,000 deadweight tons) and Suezmaxes (150,000 deadweight tons), are up 33% and 39%, respectively, in the last week.
The Wall Street consensus for June 2004 quarter earnings per share for Teekay Shipping (TK, news, msgs) has climbed to $1.21 from 81 cents a share in the last 30 days. As of May 25, I’m raising my December 2004 target price to $40 a share from a split-adjusted $38.50.
When China brakes, the world slows
Take the revaluation of China’s yuan off the front burner for now. (Two months or so?)
The Chinese government has apparently decided that recent measures amount to a de facto revaluation of the Chinese currency, so more formal action isn’t necessary.
This may not be good news for workers in industries facing competition from China. It is, however, good news for global financial markets that have been rattled by uncertainty about what would happen to global economic growth if China allowed the yuan to rise in value against other currencies. In remarks at the meeting of the Asian Development Bank, China’s vice finance minister Li Yong noted that the reduction of tax rebates on exports, cuts on tariffs on imported goods, and recent Chinese domestic inflation at 3.8%, is equivalent to a 5% to 8% appreciation in the yuan. So, for the moment, there will be no change in the official peg that links the value of the Chinese currency to the U.S. dollar.
Currently, the yuan trades at 8.28 to the dollar, a value that some economists and many U.S. politicians believe is artificially low.
Editor's Note: A new Jubak’s Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned shares in the following equities mentioned in this column: BP. He does not own short positions in any stock mentioned in this column.
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