Analysts Again Say Profits Will Fall Even as Oil Rises; Naysayers Have 0-2 Record
The Wall Street Journal, July 19
By David Reilly
LONDON -- With oil back above $40 (about €32) a barrel, it would seem like a no-brainer that already-hot European energy stocks could have more room to run.
But that conclusion flies in the face of prevailing market wisdom.
Despite high oil prices, consensus earnings projections for European energy companies see profits falling by 10% in 2005, according to JCF Group. That, in turn, could signal that energy-company stocks could soon run out of gas.
What gives?
Analysts estimating energy companies' profits try to look through current oil prices and base earnings expectations on long-term price outlooks, generally under $30 a barrel. The only problem: For the past two years markets have consistently gotten the profits outlook wrong as the price of oil refused to fall back to these so-called normal levels. That caused markets to underestimate profit growth at energy companies and undervalue their stocks.
Deciding whether the consensus on energy companies' profits is off base or not is particularly important for European stock investors. The energy sector accounts for 12% of the S&P Europe 350 stock index, making it the second biggest group of companies in Europe after financial firms. In the U.S., by contrast, energy companies make up just 6% of the S&P 500's market capitalization and rank seventh out of 10 sectors in terms of size.
Among the European heavyweights: BP PLC in the United Kingdom, TotalFinaElf SA in France, Eni SpA in Italy, Repsol YPF SA in Spain and Anglo-Dutch Royal Dutch/Shell Group.
Last December, for example, analysts were similarly forecasting that European energy-sector profits would fall 10% in 2004. Today the consensus estimates call for profit growth of 16% this year, and energy stocks were the second-best performing sector during the first six months of 2004 after utilities.
Given where the consensus is on 2005 profits, some observers have a feeling of deja vu.
"Once again, people are extrapolating that there's going to be a dramatic fall in the oil price and that will impact earnings," says Clive McDonnell, European equity strategist at Standard & Poor's equity research. "So for the second year running now, we have a situation where analysts are saying, 'OK, we were wrong, but next year really is the year where it's going to fall.' "
That's looking less and less likely, said Bobby Rakhit, a director at JCF. "We're going to have to see upward revisions," of estimates of energy companies' profits, he added.
Bolstering that view was a sharp rise in oil prices last week. Those included a 4% gain on Wednesday after the International Energy Agency said demand for oil was growing at its quickest pace in more than 20 years, while production was having trouble keeping pace. Later in the week, an unexpected drop in U.S. crude oil and gasoline-inventory data added to supply worries.
Despite the gloomy consensus outlook, European energy companies could "continue to provide earnings surprises," said Jay Bhutani, global energy analyst at Credit Suisse Asset Management in London and co-manager of the $100 million CS EF Global Energy fund. At worst, energy stocks aren't "going to fall from here," he added. That's despite a 10.6% year-to-date gain for the Dow Jones Stoxx energy share index. So why is the consensus so downbeat? And why have markets consistently misjudged the price of oil and, in turn, the profit potential of these companies over the past two years?
On the demand side, many analysts didn't expect U.S. growth to pick up as sharply as it did. Also, production from countries outside the Organization of Petroleum Exporting Countries has disappointed, giving the cartel more power to keep prices higher. At the same time, many big oil companies were focused on integrating mergers from the late 1990s and curtailed investment in exploration and production in recent years.
Then there is geopolitical uncertainty, the war in Iraq and the constant threat of terror attacks. Many analysts believe the current oil price includes a political risk premium of about $8-$9 a barrel.
Oil bears believe that premium will erode if the geopolitical situation stabilizes, and prices should fall as production of oil increases in response to higher prices. David Allen, senior energy analyst at Pioneer Investments in Dublin, believes the high price of oil itself could undermine energy company profits. That's because a higher price leads to higher production costs, which eventually impact energy company profits.
For this reason, he agrees with brokerage analysts who believe that energy company profits will fall next year. Current returns on capital for production activities of 20% to 25% at energy companies "won't be defendable long term," Mr. Allen said. Such high returns will prompt companies to invest more in exploration and production, while service-company costs will go up because there is more demand for their business. Combined that will bring down returns and dampen profits, Mr. Allen said.
"I am sure that if oil price is flat [even at today's prices] for the next two years, you'll see earnings coming down rather than up," he added.
That said, history argues in the energy companies' favor. Since Dec. 31, 1986, the DJ Stoxx energy sector index has posted a cumulative return of 353%. That performance outpaces every other sector except for health-care companies, which have risen a total of 682% during the same time. |
