Oil and Energy
17 Sep 2005
There is more to the Energy sector than oil, but that's what has grabbed the most attention lately.
Please read this first: Following is an independent investment commentary and analysis from the Reuters.com investment channel expressing views that are not connected with Reuters News.
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When looking at the oil market over the last couple of years, many words come to mind. Amazing. Crazy. Wild. All of these seem to fit. Here's my favorite: Volatile. When we wrote about Energy stocks back on 05/14/2005, we talked about how the price of a barrel of oil broke into the $50s, before settling back in the $40s. Here it is, not even six months later, and the price for a barrel of oil is in the $60s, after recently pulling back from the $70s. There are many reasons for this recent price performance. This week, the Reuters Select Top Down article series looks at companies in the Energy sector. Today, we briefly discuss this theme and a couple of Energy companies that recently appeared on at least one Reuters Select stock screen. In the coming, we will touch on a handful of such companies in more detail.
On a weekly basis, Reuters Select Top Down articles highlight a sector, industry, or other economic segment. Unlike the Bottom Up articles, which focus on a particular screen, and discuss some of the companies that appear on that screen, the Top Down articles focus on a particular segment of the economy, and then discuss some of the companies from that segment that appeared recently on any Reuters Select stock screen.
Note: You can click here to download the free Excel users' console spreadsheet that accompanies this article. It contains detailed performance information about the screens, identification of which other screens or risk alert signals are applicable to each stock, and it has tools to help you prioritize among the stocks making the screen and value each one based on trends and prospects for EPS and/or Sales per share.
What A Ride
Every now and then I come across an investment where, in hindsight, I wish I took my life savings, maxed out the cash advances on my credit cards, sold all of my worldly possessions, and threw all of that money into the investment. Generally, when I think of such missed opportunities, they are hot stocks that skyrocketed at the their IPO and continued to climb. More recently, though, it's been oil.
When I last wrote about the Energy sector, oil was trading in the $40s, after it had broken into the $50s but then pulled back a bit. Since then, it climbed through the $50s again, kept going through the $60s, and even passed into the $70s for a bit. For a while, at least, it seemed as if the price for a barrel of oil would hit $100, as some analysts had estimated. Thankfully (for the consumer, anyway), the price of oil slipped back into the $60s again.
In the earlier article, I touched on some of the reasons why the price of oil had climbed to such heights. Global economic growth factored in there. Last year, the global economy expanded at a solid clip, and, as production increased, demand for energy - one of the factors of production - also increased. Although the rate of economic growth appears to have eased in the United States - the world's largest economy and consumer of oil-refined products - overall demand here remains very solid. And, of course, there's China. As China Inc. has been expanding, the country's hunger for energy has also been climbing. And there is little to suggest a significant departure from this trend in the near to intermediate term.
Indeed, these two countries demand a lot of oil. In fact, the United States and China, two of the key consumers of oil in the world, were dubbed The Oiloholics in the August 27th - September 2nd 2005 edition of The Economist.
There is a lot to this, but to say that the rise in oil prices stems entirely from demand would be omitting the supply side of the equation. Apparently, part of the oil issue stems from insufficient refinery capacity, helping to create a bottleneck along the way.
This brings us to the latest rally and pullback in oil prices. Enter hurricane Katrina, which blew through the Gulf Coast, causing oil drilling and refining facilities in the region to close. Many news agencies, including this one, have shown pictures of the destruction in the wake of the hurricane. Some of these photos have been of things like oil rigs from the Gulf washing up on shore or other oil rigs getting caught under a bridge or something of the sort.
Then, there were the news reports of gasoline shortages, and the price at the pump jumped considerably. Drivers lined up their cars for gas before the price climbed even higher. Some gas stations ran out, altogether. In all, the price of gas climbed well into the $3 range for a gallon across much of the country. Apparently, the price of gas climbed to about $6 a gallon in a part of Georgia. And that's pretty much when we start talking about things like price gouging.
So where do we stand now?
It seems that the US oil industry is still feeling the affects of Katrina. Apparently, 5% of the US refining capacity, along with nearly half of the country's oil production in the Gulf of Mexico was still offline, according to a September 13 Reuters news article. Even though the price of oil has slipped from its record high, it still remained quite lofty, hovering at about $63 a barrel - more than $7 off of their high from just two weeks ago - at the time of this writing.
As the price of oil has climbed, so has the price of many oil-related-company stocks. This has elevated many valuations. I'm not just talking about the typical price to earnings (P/E) ratio, which is based on trailing twelve-month (TTM) earnings per share (EPS), or even the P/Sales or P/Cash Flow metrics. High levels there don't bother me so much; they compare today's price, which is based on expected future performance, relative to the company's past performance. One metric where the valuations are quite lofty, and this is a point of concern, is the PEG ratio.
Frequent readers of this column know that I often look at a company's PEG ratio. The PEG is effectively the forward P/E ratio - based on expected EPS instead of TTM EPS - relative to the consensus of analyst estimates for the company's long-term EPS growth rate. Lower PEG ratios indicate better values. If you consider yourself a very conservative Value investor, then you will probably want to focus on companies that have PEG ratios below parity. However, PEGs slightly above 1.00 are still reasonable. After all, how much of difference is there really between 0.99 and 1.01? Not much. The time to really reflect on a PEG is when it approaches 2.00. Generally speaking, PEGs above that level are more indicative of momentum plays and are better suited for more risk-tolerant Growth investors.
Here's where things get really interesting. Many of the Energy companies that recently came across at least one of the Reuters Select stock screens, even some of the more Value-oriented screens, have PEGs well over 3.00. Flags should be going up. Some of the PEGs I've seen recently have definitely made me reflect on the price-appreciation potential of many of these stocks. Of course, if the price of oil continues to climb and the actual EPS growth rate comes in much higher than analysts currently expect, then the current stocks prices might not be so high after all. But I'm not ready to buy that just yet.
So where are we going from here? The short answer is: Beats me.
When I was working on my master's degree in economics, I wrote my thesis paper on forecasting oil prices. I don't want to put you to sleep with a discussion of the econometric analyses, but I will say that there are a lot of variables that go into the different models.
Figure, whenever you look at a market, there are two sides: supply and demand. On the one hand, some people look to sell or supply a certain amount of a good at a specific price. On the other hand, some people want to buy or demand a certain amount of a good at a specific price. Leaving aside government regulations or similar factors, which can impose price ceilings and floors, the general workings of a market are pretty simple. With oil, demand is based on certain necessities - heating a house, driving a car, operating a factory, and so on - in addition to what could be thought of as a luxury - flying or driving for a vacation, taking a cruise, and the like.
On the supply side, we have exploration & production, which feeds into refining oil into gasoline, jet fuel, plastics, and so on. As we saw during the 1970s, political tensions can impact supply; so can striking workers, inclement weather and natural disasters, and so on.
As you can see, there are a lot of variables at play when it comes to oil prices. Still, it helps to think of things in terms of the simple supply and demand relationship.
On the demand side, the change has been small in recent months. We see the pace of economic growth in the US slowing. The Federal Reserve has been very good about raising short-term interest rates to ease growth and subdue inflationary pressure. The key factor here is that it generally takes between six and 18 months for a change in interest rates to fully impact the domestic economy. As such, we have yet to see much of the Fed's efforts work their way through the economy. Also, just given the high price of oil, consumers have been forced to allocate more of their budgets to their commuting costs, which leaves less for other areas. The impact, thus far, has not been great, but there is potential for this to change, particularly if gasoline prices remain high for a protracted period. Given these factors, it seems that demand will likely remain quite solid, though the pace of growth in demand should lighten up.
Now what about the supply side? That goes back to the production, drilling, and refining companies. And this will be discussed in more detail as we look at some of the companies in this sector. Of course, there are certain factors to consider, with the big one being the upcoming OPEC meeting on 09/19/2005 in Vienna.
Of course, there is more to the Energy sector than just oil. Coal is still a key source of energy in the US, and the push for cleaner coal-burning facilities has helped to increase the demand for even high-sulfur coal - a thought that was sacrilege a few years back.
Enough of that; let's take a moment for a quick look at a couple of the Energy companies that recently came across the Reuters Select stock screens.
Some Companies
Let's start off with a look at Baker Hughes Inc. (BHI), which operates in the Oil Well Services industry. BHI recently appeared on the Reuters Select stock screens in the Value category for Favored Value Plays and in the Quality arena for Strong Operating Margins.
BHI is a leading provider of drilling, formation evaluation and production technology that serves the worldwide oil and gas industry. BHI was formed when Baker International and Hughes Tool Company merged in 1987, but the histories of these two companies goes back about 100 years. Today, not only is BHI a heavy hitter in the world of Oil Well Services & Equipment, but it is also a dominant player in many of its niche markets.
BHI's revenue growth rate has accelerated in the trailing twelve-month (TTM) period from its five-year average, but remains slower than the Industry's pace. By comparison, the company's EPS growth rate has also accelerated of late, maintaining its relative advantage. BHI's profit margins have widened of late, enabling the company to maintain a slight superiority over the Industry's figures. Although BHI's dividends have not grown over the last five years, this still compares favorably with the Industry's 14.50% contraction in the period. BHI currently allocates more than the peer average of its net income to dividends, yet its current dividend yield is considerably lower. BHI appears to have a balance sheet that is stronger than the peer average.
Next, we turn our attention to ConocoPhillips (COP), from the Integrated Oil & Gas industry. COP was formed when Conoco and Phillips Petroleum merged in August 2002. This marriage created one of the world's largest oil companies. COP appeared on the Reuters Select Value screen for Favored Value Plays.
COP's revenue and EPS growth rates over the long haul and of late exceed the respective Industry averages. But, the company's profit margins, despite recent widening, still fall short of the peer norm. Over the last five years, the company's dividend growth rate has slightly outpaced the Industry mean, yet COP still doles out considerably less of its net income as dividends than its peers do; its dividend yield is also lower. Although COP has relatively more debt on its books than the Industry average, the company appears to be better able to handle this debt.
Those are two examples of Energy-related companies that recently came across the Reuters Select stock screens. In the coming week, we will look at several such names in more detail.
What did you think of this article? Let me know.
This article launches our top-down investing strategy for the week ahead: Reuters Select Energy.
Also, be sure to check today's other strategy article introducing the bottom-up theme for the coming week: Reuters Select Growth.
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