5 big-picture reasons to snap up energy stocks
Jubak's Journal
Notoriously conservative energy conglomerates are now planning their projects against $20 crude. Here's why that's even more bullish than $35 spot prices.
By Jim Jubak
Quiz time for energy investors: Which of these events is the most important indicator of the future gains or losses in energy stocks?
* March 29’s retreat in the price of West Texas crude that took the price of a barrel of oil to a daily low just a couple of cents above $35, setting off speculation that oil prices had finally begun to retreat back toward the $28-a-barrel benchmark of the Organization of Petroleum Exporting Countries (OPEC).
* March 30’s early day spike in oil prices that reversed the previous day’s decline and raised fears, again, that oil was headed for $40 a barrel.
* BP (BP, news, msgs)’s March 29 announcement that it would use an estimate of $20 a barrel when planning for future capital spending.
If you picked anything other than the last choice, it’s time to go back and review that chapter in The Investor’s Manual titled “Stocks trade on future expectations.”
Even if you picked the third choice, you might not understand why, with oil trading at $35 a barrel, BP’s decision to use the $20 a barrel projection is wildly bullish for energy stocks. In that case, you haven’t been paying attention to what’s been driving energy stocks higher for the last year.
So let’s make sure we’re all on the same page. Then, we’ll look at why BP’s projections, to be followed by planning on $25-a-barrel oil sometime in the next three years, makes energy stocks a sector that you must overweight over the next five to 10 years.
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Slow and steady expectations fuel stock prices
Short-term oil price shifts are important and affect the value of equities. For energy stocks, though, they are not nearly as important as the slow and steady drift of future expectations by corporate managers, Wall Street analysts and investors.
The critical number to watch is the spread between the projected oil price that energy company execs use in their planning and the price that Wall Street analysts and speculators use to project stock prices and trade oil futures.
Logic would argue that these two numbers would be the same. That’s not the case, however, because the dangers and rewards of being too conservative and too optimistic about future prices aren’t equal.
Here’s what I mean. Nobody really minds if an energy project is wildly more profitable than estimated because the price of oil turns out to be higher than the company projected.
But plan for $30-a-barrel oil, and a CEO can wash $1 billion down the drain if crude suddenly tumbles to $20. If an analyst calculates a price target for Exxon Mobil (XOM, news, msgs) at $30 a barrel, but oil prices fall to $25, he could face job-threatening questions for the firm’s investment bankers.
The dangers of being too optimistic rise disproportionately as you look out over longer and longer time periods. The oil company executive is planning for exploration and production projects that may be 10 years away from producing a drop of oil. The Wall Street analyst, working backward from future cash flows to calculate the value of a stock today, isn’t working that far in advance. Five-year numbers, however, are critical in determining present value.
So the numbers used by the oil companies and by the analysts always lag (play it too conservative) when energy prices are rising, and they always lag (play it too optimistic) when energy prices are falling.
The gap in the spread is huge
Right now, with energy prices rising, there’s a huge gap between the projections the oil companies are using now to plan new projects and the consensus on oil prices for the next year, two years or more.
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Take BP’s recent decision to use $20 a barrel as the basis for planning new investments. The new projection replaces an earlier assumption of $16-a-barrel oil -- a price that oil stock skeptics used two to three years ago. And back then, that number represented the conservative end of the consensus on long-term oil prices.
Since then, the consensus projection has moved up to $20 a barrel. Then, it reached $23. Now, according to A.G. Edwards, the Wall Street consensus calls for $28 a barrel in 2004 and $25.40 in 2005.
Even in projecting $20, BP has clearly left itself a lot of room for error.
You can see the same process at work on Wall Street.
In a November 2003 research report on Exxon Mobil, Lehman Brothers forecast “a sharp retreat to $22 in 2004.” The investment house went on to project $20-a-barrel oil by 2005. It wasn’t until the company’s March 30 report on the stock that Lehman Brothers raised its estimate for 2004 to $25 from $22.
The expected retreat in oil prices, according to Wall Street analysts, has shifted out from 2004 to 2005 for the most part:
* In a March report on ChevronTexaco (CVX, news, msgs), Smith Barney moved its 2004 projection up to $28 a barrel. But it sees domestic crude falling to $24 in “the long term.”
* On March 11, Merrill Lynch said crude in 2004 would average $27.70 a barrel -- solidly in line with the consensus. But Merrill sees the price of crude dropping from $32 in the first quarter to $25.50 by December. Merrill’s estimate for all of 2005: $24.
So how all this help you in deciding whether to buy energy stocks now? Three ways:
Crude has to stay at only $25 a barrel or higher. It’s not necessary for oil prices to stay at $35 or move up to $40 for oil stocks to go up. Almost no one on Wall Street has a buy out on Exxon Mobil or BP or Talisman Energy (TLM, news, msgs) because they believe oil will finish this year at $38. To keep Wall Street analysts raising their earnings estimates and their price target, the price of oil simply needs to stay far enough above those $25 projections by the end of 2004.
Long-term projections are very resistant to change. Abandoning a view that oil prices will return to $17 per barrel (or, at worst, $20) means admitting that we’ve entered a new era in global energy supply and demand. No analyst or CEO will willingly pioneer that frontier. It’s a rare oil analyst who can state, as Lehman Brothers’ Paul Cheng did in a March 30 report, that “the global crude oil market’s long-term equilibrium price level may have indeed shifted to a higher range.”
Increased political risk and long-term downtrends in industry inventory levels (plus the lengthening of oil supply routes) has led to an irreversible rise in the risk premiums that have to be built into oil prices, he argues. That, in turn, means an irreversible rise in the market equilibrium price of oil. If Cheng is correct -- and I think he is -- investors still have lots of time to get on board the energy bandwagon. Most of Wall Street certainly isn’t there yet.
Higher projected oil prices are only now starting to work their way into exploration and production budgets. That’s because of those big lead times oil companies require. BP’s move to projecting $20 a barrel from $16 gives BP more future cash flow to plan to invest. It also means more potential investments will be profitable. Increases in capital budgets are just starting to lead to boosts in spending on drilling, oil field management and oil transportation projects.
Oil and gas service stocks are worth considering
If oil exploration and production stocks seem fully priced to you as an investor, take a look at oil drilling and service stocks, valuing them on reasonable mid-cycle cash flows. The projection lag guarantees them more headroom.
One oil drilling and services stock to look at is Oceaneering International (OII, news, msgs). Shares in the Houston company have taken a beating recently; they trade at just 24 times trailing-12-month earnings per share. Wall Street is expecting earnings to grow by 35% this year and by 20% in 2005. If I’m right about the projection lag, the 2005 figure is likely to be far too conservative.
Unless you really do think oil is headed back to $20 a barrel soon.
New developments on past columns
First-quarter 2004 performance for Jubak’s Picks
It’s time for the end of quarter (and longer) performance numbers on Jubak’s Picks. Here’s how I did against the major indexes:
Jubak’s picks vs. the major averages
Index First quarter 2004 Trailing 12 months
Jubak's picks 7% 54%
Nasdaq Composite 0% 49%
Standard & Poor's 500 1% 33%
Dow Jones Industrial Average -1% 30%
Pretty good numbers, and, as we get further and further away from the bust of 2000, the numbers look better. Here are the three-year numbers and the numbers since the inception of the portfolio:
Jubak vs. the indexes -- the long-run picture
Index 3-year return* From inception**
Jubak's picks +18% +106%
Nasdaq Composite +8% +51%
Standard & Poor's 500 -2% +38%
Dow Jones Industrial Average +5% +46%
*April 1, 2001 through March 31, 2004. **May 7, 1997 through March 31, 2004.
As is my practice, I will update these performance numbers at the end of the next quarter in June.
“8 stocks to watch in a wondering market”
On March 29, PepsiCo (PEP, news, msgs) said it would increase its annual dividend by 44% to 92 cents a share from 64 cents a share. At the stock’s March 31 closing price, that brings PepsiCo’s yield to 1.7%, a big improvement but still below the 2% yield paid by Coca-Cola (KO, news, msgs). The Pepsico board also has authorized the repurchase of as much of $7 billion of company stock over the next three years. (The company’s current $5 billion repurchase program, begun in August 2002, has just about run its course.) The stock rallied on the news because investors, who really don’t want PepsiCo to disrupt the running of its cash machine with a messy acquisition, were reassured that the company had put all this cash to other uses.
It also didn’t hurt that PepsiCo said that first-quarter earnings would come in at 46 cents a share above the current Wall Street consensus. Earnings per share for the full year should be at the high end of Wall Street’s current projections of $2.27 to $2.29 a share.
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 or controlled shares in the following equities mentioned in this column: BP and Pepsico. He does not own short positions in any stock mentioned in this column.
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