Globe&Mail column. Mentions PCP, CNQ, PD, ESI and MAV - Pan Cdn., Cdn. Natural, Precision, Ensign and Maverick (ex-Prudential)
How to Play the Oil Crunch
Andrew Bell 07:05 EDT Saturday, October 07, 2000
It's beginning to look like another oil shock.
Crude traded at more than $31 (U.S.) a barrel in New York this week, down from a 10-year high of almost $38 in September but still up 30 per cent in a year.
Prices have now soared threefold from their lows of less than $11 a barrel at the end of 1998, driven by surging demand that has so far exhausted global supply.
So how should investors prepare for an era of higher energy prices? Buying oil stocks seems like a no-brainer, but get ready for nasty spills in energy shares along the way if you follow that strategy.
"There are so many other cross-currents going on in the market," muses Sam Stovall, sector strategist at Standard & Poor's Corp. in New York.
Saudi Arabia, the world's biggest oil exporter and the driving force behind the Organization of Petroleum Exporting Countries, has said publicly that it favours $25 oil -- that price would represent a sharp fall from this week's levels.
And Mr. Stovall's research shows that over the past two decades, U.S. tech stocks, not energy shares, have been the most consistent winners when oil prices rise. "Even the energy index doesn't necessarily go up and down because of oil."
That's partly because oil stocks move on expectations about future oil prices and not the current price. "Oil prices might be trending higher, but if investors look six months down the road and say 'nah, this won't last' . . . energy shares [will be] heading lower," Mr. Stovall says.
The bottom line with climbing oil prices, most analysts and economists say, is that they'll hurt -- and perhaps wipe out -- economic growth around the world. "The longer you keep oil prices high, the greater the odds of a global slowdown, which has already begun," says Vincent Lépine, senior economist at National Bank Financial.
No surprise there -- but for investors, it suggests some interesting places to take refuge and even make money.
Opportunities
Oil producers will blossom in the medium and long term as higher product prices turbocharge their bottom line.
A slowing world economy means lower interest rates -- and that's a great environment in which to own bonds.
Lower interest rates boost profits at financial services companies such as banks, especially if the economic slowdown isn't wicked enough to increase their problem loans.
Falling interest rates and inflation may also be great for soaring technology shares, which usually represent a wager on profit and dividends in the distant future.
Whatever happens to the economy, people still have to eat and stay healthy. So food and pharmaceutical stocks, known as consumer staples, are likely to thrive.
That rising black tide of oil will boost demand for other forms of energy such as natural gas.
But the disruption and trauma in the world economy caused by an oil shock will inevitably carry a cost for investors.
Hazards
Consumers stricken by higher gas prices will also have their confidence eroded by slower economic growth. So beware of auto makers and other companies that make big-ticket consumer goods. And steer clear of retailers.
A subdued world economy will have little appetite for basic commodities such as base metals and forest products.
High fuel costs will scythe into the earnings of airlines and other transportation companies.
Big energy users such as metal smelters and chemical makers face a crippling rise in their costs. And chemical producers that use oil or gas as raw material face a double blow as the price of their feedstock also climbs.
Europe and, especially, Asia are at risk because both import most of their energy. Both regions already have currency woes that have forced them to hike interest rates, compounding their economic difficulties.
The obvious first stop for investors who want to make money on expensive energy is buying the companies that pump oil and gas out of the ground. Their profits could soon be gigantic enough to force some to start paying taxes and even dividends for the first time.
Producers' earnings have already exploded this year as crude prices climb. For example, giant PanCanadian Petroleum Ltd. predicts its profit in 2000 will more than double to $731-million (Canadian) or $2.88 a share, based on an average oil price of $27 (U.S.) a barrel. As of this week, the company's shares had gained 61 per cent in 2000, trading at $37.05 (Canadian) on the Toronto Stock Exchange.
Don't expect to find any screaming bargains among energy stocks: The TSE's index of oil and gas shares has climbed 40 per cent this year, the best showing by any group.
But the group has been led higher by major natural gas producers, whose profits are on fire as natural gas prices hit record peaks, analysts say. They argue that the fun for oil stocks is just beginning because investors still haven't cottoned on to the explosive growth in store for companies with a heavy dependence on oil production, as opposed to gas.
The market seems to be valuing oil assets at only $20 (U.S.) to $22 a barrel, says John Mawdsley, an analyst with FirstEnergy Capital Corp. in Calgary. "The oil-weighted stocks have not seen the move that the gas-weighted stocks have."
For those who want a pure play on oil, with relatively little natural gas production, recent prices for Canadian Natural Resources Ltd. have been "a steal," according to FirstEnergy Capital Corp. analyst Scott Inglis.
The company's stock traded this week at $50.95 (Canadian), up 45 per cent this year, but Mr. Inglis reckons the shares are headed for $70 in a year. In a mid-August report, he forecast that Canadian Natural, fresh from swallowing Ranger Oil Ltd. in a $1.6-billion deal, has enough development projects to ramp up oil production 10 per cent a year. Based on a $45 price for Canadian Natural's shares, he calculated the "stock remains very cheap, trading at 4.1 debt-adjusted cash flow [in 2000] and seven times earnings."
For an even bigger jolt from high oil prices, analysts advise, buy shares in oilfield-services companies, whose revenue and profit margins explode even faster than those of oil companies when producers scale up their drilling.
In a market obsessed with upward earnings revisions, that could be where you want to be, argues Fred Sturm, manager of the $170-million Universal Canadian Resource Fund. "We are going to see the highest rates of profit and cash-flow increase from the drilling [services] sector."
And with service stocks, at least, you may have a shot at getting in early because drilling in Western Canada has so far been much more subdued than expected. "It's not as high as we once thought it was going to be," says Mr. Mawdsley at FirstEnergy.
"We thought with higher oil prices, people were just going to start drilling like mad." Instead, he said, oil companies have been using their cash to buy back their own shares on the market.
Shares of Precision Drilling Corp. took a pounding at the end of August after the oil and gas services company said poor weather in Alberta had hurt business. However, the stock is still up 46 per cent this year to about $54.
The huge company has just taken over smaller rival CenAlta Energy Services Inc. for just over $277-million, including $55-million in debt. That gives it 262 rigs, or about one-third of Canada's fleet.
Buy the stock now, say FirstEnergy analysts John McAleer and Jason Konzuk. In a Sept. 12 report, they predicted Precision shares will hit $77 within a year. The company's profit is likely to grow fourfold to $113-million or $2.33 a share in 2000, the analysts say.
Precision -- which trades at around 26 times projected profit for this year -- is no longer a screaming bargain, C.I.'s Mr. Bushell says. "It's probably, I would say, in the [top] third of its valuation range."
But he calculates that the market is valuing Precision at only around 60 per cent of the price of similar U.S. companies, which could produce a lucrative U.S. takeover bid for the company and for rival Ensign Resource Service Group Inc. "They could offer substantially more than the current share price."
Finally one reasonably priced way to play soaring natural gas is Maverick Tube Corp. of Chesterfield, Mo., says Poe Fratt, an analyst with A.G. Edwards in St. Louis.
The company just took over Calgary-based Prudential Steel Ltd. for almost $500-million (U.S.) to become the largest maker of tubular products and line pipe for the energy industry. Maverick stock has risen about 10 per cent this year, trading at $27.06 on the New York Stock exchange this week.
"Maverick is levered to North American drilling activity," the analyst says. "And that's mainly natural-gas driven."
He reckons the company will make about $1.75 a share next year, meaning that it's trading at a modest multiple of about 15 times earnings.
Finally, don't be tempted by the classic strategy of juicing your returns by betting on small, less efficient and debt-laden energy producers that become recovery candidates when oil rises, warns fund manager Mr. Sturm.
If oil does give up some of its gains, moving down to the mid-$20s, then oil stocks will retrench sharply. And the lesser-quality names will fall fastest, he predicts. "There has been no precedent of a sector outperforming and getting increasing investor interest while the commodity price has been in decline."
Then there's the possibility that technology shares will do well even if oil goes through the roof. That may seem odd given the lofty prices of tech shares -- even battered Intel Corp. still trades at almost 50 times this year's earnings.
But tech companies don't use much energy and their fortunes don't wax and wane in line with the economy. And if expensive oil leads to lower inflation, it may favour high-priced growth stocks. That's because investors will be more willing to tie their money up in such long-term plays because the value of the money isn't being eroded too fast.
"The tech sector is less sensitive to fluctuations in oil prices," says Mr. Lépine of National Bank Financial.
But the classic antidote to economic weakness has long been food and drug stocks. Their earnings typically grow slowly but they're also relatively immune to downturns in output. After all, consumers can't stop eating.
Stick to the giant names, many analysts advise. John Murphy of Credit Suisse First Boston last month called U.S. drugstore giant Walgreen Co. a "buy." The company's shares traded at $37.75 in New York this week, up 29 per cent this year, giving it a market capitalization of $38-billion.
Walgreen shares are headed for $43 within a year as the company relentlessly increases earnings from its 3,000 stores, Mr. Murphy predicted. He estimates profit will hit 85 cents a share in the current fiscal year, up from 74 cents last year and 62 cents the year before.
Ironically, by hobbling economic growth, expensive oil may well turn out to be a deflationary force. In other words, as wealth is diverted to oil producers, consumers will have less to spend on other goods and services. That fall in demand will depress the rate of price increases in the world economy as a whole and could even lead to falling prices. Stable or falling prices mean low interest rates -- and that's a great environment in which to own bonds.
"I view this as a deflationary shock for the global economy," says David Rosenberg, chief Canadian economist at Merrill Lynch Canada Inc.
He recommends a "barbelled" portfolio with two very different sets of holdings at either end: Energy stocks levered to the booming natural gas market on the one hand and, on the other, "interest-sensitive" stocks such as financial services companies that do well when interest rates fall. Canadian investors have already adopted that strategy: As of this week, financial services had surged 32 per cent this year on the TSE, lagging only the energy sector.
Mind you, as with oil stocks, financial services shares face choppy waters until the inflationary effects of higher oil prices have worked through the system.
Just this week, the U.S. Federal Reserve Board spooked investors by warning that "the increase in energy prices . . . poses a risk of raising inflation expectations."
For those who can stand the turbulence, CIBC World Markets analyst Mario Mendonca last month reiterated his "strong buy" rating on newly public life insurance giant Manulife Financial Corp. The company's shares hit a record $32.90 (Canadian) in Toronto this week, up more than 80 per cent from their $18 issue price just over a year ago.
In an Aug. 28 report, Mr. Mendonca said the company's sprawling operations in Asia, Canada and the United States give its earnings stability. Its Asian operations, particularly in Hong Kong, "provide the company with a strong growth platform outside of North America," he said, predicting that overall share earnings will come in at $2.08 this year and $2.40 in 2001.
But what about the losers if oil prices stay high, at around the $25 (U.S.) level the Saudis would like to see?
"High oil prices [are] equivalent to a tax on consumers," says S&P's Mr. Stovall. "Retailing would likely be hurt."
The public's traditional reaction to such gloomy conditions has long been to defer the purchase of big-ticket items such as autos -- known as consumer cyclicals because their sales rise and fall in line with the general economy.
Investors have already abandoned such companies in the United States. As of this week, household furniture and appliance stocks in the S&P 500-share index were down 38 per cent this year. The TSE's department stores index had dropped 18 per cent.
Also at risk: industries that use lots of power. "Sectors that are energy-dependent, like transports, steel, chemicals, typically underperform in periods when oil prices" are rising, Merrill's Mr. Rosenberg says.
And a subdued world economy will have little appetite for basic commodities such as base metals and forest products. In fact, basic material companies such as steel and aluminum producers may find themselves caught in a vise -- prices for their products will tank but their energy costs will soar.
"We're already seeing other commodity prices softening," National Bank's Mr. Lépine says.
But he warns that the real damage is being done to Asia, with its heavy dependence on imported oil and old-economy manufacturing. "Since the rise in energy costs is not offset by higher export prices, corporate Asia is taking a severe hit," Mr. Lépine warned in a Sept. 11 commentary.
The damage to Asian markets has already been horrendous. Singapore stocks have slumped 20 per cent this year, Japan is down 16 per cent and even Hong Kong, whose great financial and real estate companies usually thrive on the prospect of lower interest rates, has lost 7 per cent. |
