Integrated oil, E&P, and R&M trading update -- Take advantage of political and weather noise to add on weakness - Goldman Sachs November 09, 2005
We believe that investors should take advantage of political noise and early warm winter weather to add to positions in the sector on weakness; we reiterate our Attractive coverage view. Our key takeaway from today's Senate hearing on "Energy prices and profits" is that constructive public policy is unlikely to impact oil supply/demand fundamentals any time soon. DOE statistics show that gasoline demand continues to recover from hurricane-induced weakness, suggesting so-called "demand destruction" was temporary and more a function of a lack of available supply as opposed to the start of a multi-year, price-driven downturn. While excessively warm winter could further pressure commodity prices, we believe energy equities are already discounting near "mid-cycle" conditions that are more consistent with 8%-10% returns on capital rather than the 20%-30%+ we expect for 2006 and 2007.
SENATE HEARINGS SUGGEST CONSTRUCTIVE PUBLIC POLICY STEPS TO ALLEVIATE TIGHT SUPPLY/DEMAND FUNDAMENTALS ARE UNLIKELY ANY TIME SOON
We have been skeptical of the view that meaningful public policy measures would be taken to alleviate tight supply/demand fundamentals. The November 9 United States Senate hearing on "Energy prices and profits" featuring the CEOs of the three largest US oil companies--Exxon Mobil, Chevron, and ConocoPhillips--plus the heads of the US operations of BP and Royal Dutch Shell further confirms our view that necessary public policy steps to proactively reduce demand and increase supply are unlikely to be forthcoming. We continue to believe that an energy crisis (what we refer to as our "super spike" view) that ultimately brings about a looser supply/demand balance is more likely.
Four key areas to consider:
(1) Conservation is needed. We believe a more constructive way to bring about lower energy prices would be for consumers to hear the message that high energy prices are a function of tight supply/demand fundamentals, geopolitical turmoil, and catastrophic hurricanes rather than "price gouging" by "greedy" oil companies. The latter, politically expedient message, in our view, lessens the likelihood of sustained conservation measures being taken. Perhaps a hearing should be held on why Congress has not created better disincentives to the continued production of low-mileage sport utility vehicles.
(2) Windfall profit taxes will not increase supply or lower demand. It remains our view that the ultimate passage of a so-called "windfall profits" tax is unlikely. However, this has been a hot topic of late. The reality is that taxing profits will neither decrease energy demand nor increase energy supply. Changing taxation policies is a risk in energy investing around the world. It is our view that just as oil service and raw material cost inflation has served to boost spot and "normalized" energy commodity prices given the need to earn a return on capital and given the propensity for companies to invest less when faced with volatility and uncertainty, so to might higher taxes further raise likely commodity price trading ranges. We fail to see how higher oil company taxation in the United States would lower energy prices for consumers.
(3) The free market miracle: Gasoline prices are now below pre-Katrina levels. We note that gasoline prices have retreated to below pre-Katrina levels. Yet, many of New Orleans' poorest residents remain displaced. We conclude oil companies have outperformed governments following the catastrophic hurricanes.
(4) Crude oil prices are set in free markets by physical and financial traders. Based on the testimony we heard (note: we were unable to witness the entire hearing), we believe oil company executives (and one in particular) did not do a very good job educating the senators on the fact that crude oil prices are set in a highly competitive free market through the interaction of many physical and financial oil traders around the world--not by the decree of one large oil exporting country and oil company (as was the example given). If traders were to bid the crude oil price too high and there really existed excess supply, the highly competitive nature of the oil industry, in our view, would result in that excess supply being sold at what would then prove to be an unsustainably high price that subsequently would fall. If the higher price does not bring about higher supply or lower demand, then we think one can usually conclude that the higher crude oil price was needed to satisfy or even ration demand. This is the environment we think we are in today.
DOE INVENTORY STATS POINT TO RECOVERING GASOLINE DEMAND
We continue to believe that underlying demand for energy remains strong, once adjustments are made for hurricane-induced supply disruptions and early warm winter weather. We note that gasoline demand continues to rebound as Gulf Coast refining supply has been brought back on-line and is moving back into positive territory on a year-over-year basis. Even distillate demand we find to be surprisingly healthy in light of the very warm weather being experienced in the US northeast--the key winter demand market. We believe investors need to differentiate between involuntary demand reductions brought on by a lack of available supply (as has been the case, in our view) and the more troubling price-driven, voluntary demand reductions brought on by a weak economy or sustained conservation measures (which would follow a multi-year "super spike" period that we think has only just begun). We believe all indications are that underlying demand remains healthy, with consumers not yet embracing a sustained, large-scale conservation effort. Furthermore, Goldman Sachs economists continue to paint an overall picture of world economies that is supportive of at least trend oil demand growth.
RISK/REWARD FOR ENERGY EQUITIES FAVORABLE FOR INVESTORS THAT CAN LOOK PAST POLITICS AND WEATHER NOISE
We believe the intermediate- to longer-term risk/reward for oil equities remains very favorable for investors that can look past US political noise and the very warm start to the winter heating season. On the latter point, we recognize that a super warm winter could further pressure commodity prices. However, with industry balance sheets ultra healthy, underlying supply/demand fundamentals continuing to appear robust, ongoing geopolitical turmoil a fact of life, and oil equity valuations now approaching "mid-cycle" levels consistent with a very conservative 8%-10% return on capital rather than 20%-30%+ we anticipate for coming years, we believe the risk/reward has become very favorable for investors that can look past short-term political and weather noise.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Brian Singer. |
