Leading Oil Analyst Foresees $26/barrel
Brent crude soars to 32 month highs, senior oil analyst Fadel Gheit finds strategic value plays in the sizzling sector, sees six months clear sailing ahead.
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The steady ascension of oil prices has planted the sweet black commodity firmly atop the news headlines, and spattered the sizzling stuff on the lips of all market observers. As the sector heats up - discussions bubble over, and Fahenstock's senior oil analyst Fadel Gheit has been inundated with calls for his expert opinion.
Voted an All-Star Analyst by the Wall Street Journal for his success as an oil exploration stock picker, Mr. Gheit shares three top picks from his extensive universe of oil stocks. Gheit believes the sector has run ahead of itself, yet uncovers plays that could realize massive benefits from possible M & A action, or international policy change. Gheit reads the market sentiment, inferring that OPEC's resolve should make for a smooth landing when the sector finally cools.
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StockHouse: Crude has broken $23 and poked above $24, hitting levels unseen in the past two and a half years. Are you looking up from here?
Fadel Gheit: This is a very big psychological barrier and probably the next stop will be $26.
StockHouse: When do you expect that to happen?
Fadel Gheit: Unless we have a major setback somewhere, I think we are likely to see $26 oil by Christmas.
StockHouse: It seems that the oil stocks can't keep pace with this. Is the market in shock with these oil prices?
Fadel Gheit: Absolutely. There is no question in my mind. It exceeded the wildest expectation of the raging bulls. No one, including the most bullish analyst who basically was shooting from the hip, and it was wishful thinking more than anything else that they thought that oil prices could rebound to $17 or $18, but nobody thought it could go to $23. And now we can even see $26.
It's feast or famine. Either we have prices that hit multi-year low, you know ten months ago or so, or we're very close to almost the highest level of oil prices outside the invasion of Kuwait in 1990.
StockHouse: What are the dangers inherent in oil going that high?
Fadel Gheit: What goes up must come down and what goes up fast must come down fast.
Having said that, at least for the time being it seems to me that the environment is almost like we're taking only green lights, nothing's stopping oil prices from moving higher. For a couple of things, OPEC is unlikely to change its production policy at the next meeting, which is in two weeks. In addition, the supply is likely to continue to shrink because of the negative impact of the sharp drop in capital spending that occurred early this year.
So when you combine that with higher than expected demand growth, Economics 101 tells you that we are going to have a continued increase in oil price.
StockHouse: How long could this environment support that?
Fadel Gheit: If we have cold winter and the economic environment remains strong, I definitely see $26 oil. Once it reaches this level I think it's going to send an alarm to OPEC because they say: okay now, let's not push our luck, let's not let this thing go out of control, and let's slowly but surely increase production to manage the soft landing.
They would love to see oil prices stabilizing at $20 or $22. Actually, only a few months ago they would've loved to see $18 oil. But again the pendulum swung too wide and too fast. They don't want to see tremendous over-reaction to some event that sends traders just punishing oil futures bringing them down, to a near collapse in a few weeks.
I hope they learn from experience - this is the first time in memory that OPEC has not cheated, has not exceeded its quota. And that is extremely positive. This is like an alcoholic that says I'm not going to touch a drink and guess what, he's been sober for seven months.
StockHouse: So you are saying that the level of compliance ...
Fadel Gheit: ... is unusually high. Even the notorious cheaters have kept their nose clean.
StockHouse: Right and the market is finally convinced of OPEC's resolve?
Fadel Gheit: The market sentiment is always: okay, show me first. The market now is convinced these guys are for real, these guys mean to live up to their promises. One of the reasons is that the sharp drop in crude oil prices really created economic pain for OPEC that is so vivid and so deep that they said we do not want to experience this anymore. I don't think that OPEC is likely to venture into testing the market on the down side because the market is very finicky and if it starts going down it could go down faster than you think - we could have a collapse and we don't want to see that.
So I think we are going to have oil prices supported. The immediate trend is definitely positive. As I said I would not be surprised at all to see $26 oil before Christmas, which is not much - another $3 from here, so its not an earthshaking move. The other thing that also a lot of people are concerned with the instability in Russia and the former Soviet Union. It's a very big reminder for the rest of the world that Russia is not a safe haven for those who are looking for alternative oil sources
What I am saying here is that in addition to the economics, the supply/demand situation fundamentals are very positive, you also see some uncertainty. The political turmoil in the Soviet Union obviously makes people think twice about how safe is the Soviet Union, how safe and secure is the oil coming out of the former Soviet Union - can we depend on that? And then obviously with all the scandals and the bribery and Yeltsin and all these things, it muddies up the picture too much.
And when you see that, it is always, always a safer ground - oil and oil investment and the commodity itself becomes a safer ground for investors.
StockHouse: Do you think we could be facing a severe supply problem as Y2K approaches?
Fadel Gheit: No, no, no. I don't want to alarm people and say okay, go run and store oil for the millennium, put it in your basement or buy empty jugs and put oil in there. That's not the case. Remember there is plenty of oil around the world. There has never been a real oil shortage. The shortage is always a figment of people's imagination, so is the glut.
StockHouse: But do you see a significant draw on the supply side before Y2K?
Fadel Gheit: What I see is faster or higher rate of demand growth than supply growth. Supply, I believe, will probably increase, but the demand will increase faster. So there will be a net draw on inventory and that is positive for oil prices.
I'm not saying that our supply is going to deteriorate, going down whatever, no. I expect next year, 1999 supply will likely be lower than 1998. That is academic. The year 2000 supply, barring anything, I think we are going to see supplies run higher because capital spending is beginning to increase. OPEC will produce more oil because OPEC has more money, they can invest more in their oil facilities, and we also see the demand could give them more room to sell more oil without really risking a drop in oil price.
StockHouse: Now you say that capital spending has begun to increase? It is a little unclear to me, as news reports indicate that capital expenditures had dropped off.
Fadel Gheit: Capital expenditure has dropped off significantly from the original budget of last year. Companies in the industry usually budget for the year ahead, like they are now finalizing the budget for the year 2000. As we see more hospitable environments that come with higher oil prices, more projects will become economically viable because it will increase the potential return on investments. That will invite more capital to come in because companies will say: hey, at $15 oil this project is not economic, at $20 oil it is economic, at $25 it is home run. So while the project is still there on paper, it can only be executed at certain price levels, or at least expectations of certain prices levels.
Now we are there. If oil companies cannot make money at $23 oil they better find some other business to be in. If the projects on the drawing board are not approved or released to execution at the current price environment they are unlikely to be economic in the future. So therefore after this initial cut in capital spending, because of the sharp drop in oil prices earlier this year, when oil prices start moving up again that encourages oil companies to breath life back into these oil companies. So they begin to increase their capital spending.
We've seen a lot of smaller companies, especially smaller companies that got whacked because of lower oil prices. These companies stopped spending period, they just shut down for all practical purposes.
StockHouse: Yes, it's really hurt their production capacity.
Fadel Gheit: Exactly, exactly. So since oil production would decline even if you maintain capital spending because it is natural field decline, you have to work twice as hard. It's like athletes. You have to work twice as hard to maintain your skill level as you get older. That's exactly what happened in oil fields.
StockHouse: So we're nowhere near the levels of capital spending we were at two years ago?
Fadel Gheit: No, no, no, no, no.
StockHouse: It's just beginning to turn around now?
Fadel Gheit: This is the sharpest decline in capital spending, percentage-wise, in the last probably ten years or so, as a percent. I don't know that exact number, but let's assume that the industry was planning to spend, let's just assume, $250 billion. Let's just pick a number. They cut capital spending say by 40% so they cut it by $100 billion so now the new number is $150 billion. Now they say okay, we're going to increase capital spending by 20%. Okay, from $150 to $180, a far cry from the original $250 that were on the books a year ago.
StockHouse: And as this is magnified for the smaller players, does this change the landscape for a fresh wave of consolidation?
Fadel Gheit: Exactly. What happens to the smaller company? You're not going to see the percentage decline or change in capital spending in the major oils. You usually see the fluctuations are extremely high at the smaller oils. Why? An Exxon [XON] might cut capital spending by 5-10%, maybe 15%, or even 20%, but the smaller companies... Occidental [OXY] cut capital spending by 80% and it's not a small company. So we were talking about total collapse, not retreat. It's a total, total collapse. The industry, I am estimating because it is like shooting at a moving target, the industry cut capital spending by approximately 40% from the original budget. So if it was $100 the revised number is $60. Now they increase it say by 10% or even 15% or even 20%, it becomes $72.
StockHouse: Those 40% capital spending cuts have occurred since February?
Fadel Gheit: Correct. It was cut early this year, capital spending was cut by approximately 40%. Anything that comes to rectify that is going to be nowhere near coming back to the original budget, will never be whole again. It will take maybe 2 to 3 years to reach the level of capital spending in 1998.
StockHouse: In light of this, have stocks have gone too far ahead of themselves?
Fadel Gheit: Absolutely. There is no question in my mind. Oil stocks are trading at unrealistic expectations right now. But guess what? Because of lack of anything else, I mean people say we've had enough Internet stocks, we're already paying huge multiples for a company that doesn't have earnings or anything to even show for years. Now let's look at some value. I mean they have done everything. They ate enough caviar, now it's time for bread. Now they are buying bread. So all the high flying multiples and whatever, I mean technology stocks and high growth stocks have...some of these stocks have doubled or tripled or quadrupled, I mean look at IBM. Do you know that IBM almost went five-fold in the last 3 years? I mean it's unbelievable. It's like why. Nobody knows, it's the same old IBM, same good old blue. They didn't change any colors.
StockHouse: So we're okay to invest in oil stocks for the next few months but we've got to know when to get out.
Fadel Gheit: Exactly. Basically clear sailing ahead for the next six months.
StockHouse: Okay, what type of warning signs would an investor look for?
Fadel Gheit: Two things. I always tell people supply is very, very important in the near term. Demand rules in the long term. We can always tinker with supply - OPEC can meet and decide to take 2 or 3 million barrels off the market. That's a decision that can be made in a short period of time. But nobody, not one country or group of countries can really manipulate the demand for energy worldwide.
Obviously price is determined by supply and demand correlation. Easy to manipulate or control supply. OPEC obviously is a producer, they can convene any time, they can call an emergency meeting, they could have impact either real or perceived impact on the behavior, the psychology of oil prices and that will have impact on oil prices.
In the long term demand is really the big factor because we can cut supply but if there is no demand prices will continue to fall.
StockHouse: Okay, so as an investor what should you get into at this late stage in the oil rally?
Fadel Gheit: As an investor you definitely want to buy under valued oil stocks and to tell you the truth there aren't too many of them. Remember that when people were selling oil stocks, dumping oil stocks, they extrapolated the current price, at the time they were dumping stock $11 or $12 oil, thinking that was staying forever. Nothing stays forever. Therefore $23 or $26 or $20 oil is not going to stay forever. Again, it's going to be a cycle. It's going to go up and it's going to go down. I can't tell you precisely when it's going to start going down, but so far, as far as I can see, it's clear sailing, it is moving higher.
StockHouse: Okay, so which types of oils do you find the most value in? Integrated oils, oil services?
Fadel Gheit: Investors, who are looking for quality and safety should look at the major integrated oils. They are unlikely to be disappointed.
StockHouse: So you're including Chevron, Texaco, Exxon and the like?
Fadel Gheit: I would take Exxon [XON] any time and go fishing for the next six months and don't worry about the market because I think Exxon will significantly outperform the market in the next six months, I mean significantly.
StockHouse: Exxon currently trades in the $80 range, how lofty if your price target going forward?
Fadel Gheit: I think Exxon could do $100 in the next 6 to 12 months. Our target on Exxon is it's $100 stock. When it's going to get there, hard to say, but I would say, I would be surprised if by next summer Exxon was not a $100 stock.
StockHouse: What other integrated oils are you bullish on?
Fadel Gheit: I like Texaco [TX] a lot because it's one of the most undervalued. But the truly most under valued oil stock is the Italian oil company Eni and the symbol is E. This is truly undervalued. It's the only large cap oil stock in the world that is selling below its levels.
StockHouse: It seems not to have been affected by rising oil prices.
Fadel Gheit: No, that's what I'm saying. It's almost like looking at somebody who had cardiac arrest and no pulse -- it is dead.
StockHouse: What will be the catalyst to bring it back to life?
Fadel Gheit: The catalyst...if the U.S. removes and the world removes the economic sanctions on Libya that will draw a lot of people's attention to this company because this is the only company that does business in Libya. By doing so no other oil company can do any business with Eni because they fall under the economic sanctions of the U.S. so it's almost like somebody had a disease and nobody wants to come near them.
StockHouse: And short of that happening?
Fadel Gheit: Short of that happening, I mean this company is also very highly leveraged to oil and gas prices. The other thing is the merger mania between oil companies that's taking place and this is the only large company that's overlooked because of the Italian government stake in the company and their golden share. But having said that I still think that the marketplace will change that, and I would not be surprised to see the government dropping its opposition to any overture from one of the major oil companies to combine with Eni.
StockHouse: How much stake does the Italian government have?
Fadel Gheit: It's a major stake, but more importantly they have the golden share which means they have veto power and that's important. But they still have big chunk of the stock. They just reduced it below 50%, so it's around 30 or 40%, but whatever it is, it's still a major, major chunk of it, so that's a drawback.
But it is the largest oil company in Europe. It is the largest oil company outside of the U.S. It has $50 billion market capitalization, it's a huge oil company that is one of the most highly integrated oil companies which means they are in all facets of the energy field. So that's truly a very cheap stock and it's trading at a ridiculously low price compared to its break-up value, or what you call net asset value.
The stock should be trading at $80, it's trading at $60. You're talking about 30% discount from where it's supposed to be and I call it the sanction penalty and the Italian government stake penalty. These are the two penalties. And it's not really well known in the U.S. and that is a very major drawback. After that my top choice is Occidental [OXY].
StockHouse: Occidental has really been on a tear this month. This was one of your favorite picks last time I spoke with you.
Fadel Gheit: Well, we've been behind the stock for a while. This is the most under valued, large cap, U.S. stock. It's just phenomenal. One catalyst on Occidental -- within two weeks Chevron must file with the U.S. Supreme Court to avoid paying $1 billion judgement to Occidental. If Chevron files, which I assume they will file the routine matter, that will give them time to breathe, but one of my suggestions is for Chevron to go and make a bid for Occidental, save itself the $1 billion, buy cheap assets, acquire huge chemical operation, combine the two companies, and save annually over $500 million. So that is a tremendous, tremendous benefit for Chevron.
StockHouse: What is your near term price target do you set for Occidental?
Fadel Gheit: $30.
StockHouse: When do you anticipate that?
Fadel Gheit: We usually set out price target for the coming 6 months, however this one could hit that much earlier.
StockHouse: Thank you very much, Mr. Gheit.
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