In Barron's weekday trader:
July 13, 1999
As Crude Oil Hits $20, the Next Stop May Be $25
By Vito J. Racanelli
Crude oil prices settled above $20 a barrel Tuesday for the first time since
1997. And who'd a-thunk it as recently as eight months ago?
Back then the world was awash in oil. With the prospect of a global world
economic recession nigh, crude prices teetered around $11 a barrel and
seemed ready to fall headlong into the single digits.
Why the rapid turnaround? The members of the
Organization of Petroleum Exporting Countries (OPEC)
have shown exceptional compliance -- about 90% -- with
production cuts they agreed to last spring. Moreover, U.S.
demand remains strong, and 1999 global demand is now projected to grow
by about 1.5%, higher than previously expected.
Even so, the wall of worry remains high. With each rally in oil prices, more
investors seem concerned that cheating by OPEC countries will reemerge with
a vengeance -- or that non-OPEC countries will ratchet up production, forcing
prices back down to the $15-$17 range.
Maybe that's why some investors have been selling into the recent rally in
energy stocks. Skeptics also note that analysts continue to cut earnings
estimates this year -- even as the stocks have surged. And hydrocarbon
exploration budgets will still be down 25%-30% in 1999.
But some increasingly bold bulls see crude prices rising to $22-$25 per barrel
in the next six to 12 months. They maintain that, having just gone through
gut-wrenching losses from the lowest oil prices in decades, OPEC nations
won't squander their newfound discipline. And they expect the Asian
economic recovery to continue, keeping demand strong.
Philip K. Verleger, who heads up PKVerleger LLC, an independent energy
consultant, says OPEC's cuts are rapidly draining crude inventories. As global
demand grows and OPEC maintains its production quotas, he says, "you
could see West Texas Intermediate (the U.S. benchmark price) at $25 per
barrel by the end of the year." Martin Schulz, an analyst with National City
Asset Management, also predicts that "OPEC will sit tight and keep a low
profile."
And on the demand side, fundamentals are looking increasingly solid. Steven
Colbert, a senior analyst at Jurika & Voyles, says, "We are returning to [a]
growth mode." Asia and developing countries in general, which supplied the
marginal demand that drove oil prices up to about $26 per barrel in early
1997, have turned the corner, he says.
That means energy stocks -- many of which have already gained anywhere
from 30% to 80% this spring -- could rally still more. "No one believes [the oil
price rise] is sustainable, but it is," says Mark Baskir, who runs Strong Capital
Management's Limited Resources Fund. Exploration and production (E&P)
and oil service companies in particular should benefit.
Why? Because Wall Street analysts still "haven't fully accounted for the
increase in oil prices in [their] earnings [estimates]," argues Schulz. So, if crude
prices go higher, these companies could report surprisingly good earnings --
and analysts would have to raise their estimates as well.
Houston-based investment bank Simmons & Co., for example, is now
predicting that international E&P spending will rise by 15 percent in both 2000
and 2001, versus a 25% drop this year. That will boost profits at service
companies.
And that's why bulls such as National City's Schulz are still snapping up energy
stocks. One favorite: Petroleum Geo-Services ASA, a Norwegian provider of
seismic data whose ADRs trade on the New York Stock Exchange. Schulz
calls it "number one in terms of seismic software." The company will soon start
to benefit from an up tick in exploration and drilling next year, he says.
Petroleum Geo-Services closed
Tuesday at 19 5/16, and it trades at
about 15.5 times First Call consensus
estimates of $1.24 per share in 2000,
which would represent an 88% rise
from its expected earnings of 66 cents a
share this year. Its long-term profit
growth is projected at about 20%.
In the E&P sector, Strong's Baskir has
been adding shares of Apache and
Devon Energy, both of which he says
made strategic acquisitions of energy properties when oil prices were
substantially lower last spring. Some 25% of his fund is now in E&P stocks.
Apache sells at 27x 2000 estimates of
$1.48 per share next year, which would
constitute a 95% rise from 1999
projected earnings of 76 cents a share.
(Apache's long-term earnings growth is
estimated at 18%.) And earnings
estimates for Apache have tripled since
March, while those for next year have
risen 50%. As oil prices continue to
rise, analysts will likely boost those
estimates as well.
Among the majors, both Baskir and Schulz like Royal Dutch Petroleum, which
owns 60% of Royal Dutch/Shell Group. Though the group's new chairman
Mark Moody-Stuart has already made great strides in turning around the oil
giant, there's still plenty potential restructuring and cost cutting left for one of
the world's largest oil companies, both investors say.
At Tuesday's close of 64, Royal Dutch
shares trade at about 35 times 1999
First Call estimates of $1.83 per share,
a projected 27% rise from 1998's
earnings. The shares also change hands
at 27x estimates of $2.39 in 2000, a
31% increase from 1999's estimated
earnings. Those P/Es are at a small
premium to its peers, whose average
earnings growth, however, is
significantly slower than that of Royal
Dutch -- in both the near and long term,
according to Baseline.
There are a couple of potential caveats to all this bullishness. OPEC meets in
September, and if oil prices are already nearing $25, the cartel might decide to
raise production then. On the other hand, the Federal Reserve may succeed in
slowing the U.S. economy so much that oil prices may begin to move in the
opposite direction.
Right now, however, either scenario seems pretty unlikely. So as oil prices
continue to rise, investors may find the rally in energy stocks isn't just a spring
fling but a summer romance that continues in the fall.
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