Barrons Article
In an otherwise bleak year for corporate earnings, the oil sector has been a gusher of good news. Consider the latest quarter, in which earnings for the companies in the S&P 500 index collectively slid some 17%. Not so the oils, however. Buoyed by lofty prices for crude and natural gas, the S&P's oil components reported a handsome profit gain of 26%.
Yet, despite such glad tidings, energy stocks are wearing the mantle of gloom. Since early June, the S&P index of integrated oil and gas producers has fallen 6%, erasing most of the sector's blistering rally in the year's first half. Moreover, some traders and investors, predicting broadly lower prices for crude oil, now expect the shares to fall even more in the months ahead. Oil stocks, they note, were a redoubt, or fortress, in the market's latest storm, climbing 5% in the past 12 months, while the S&P backtracked 20%. But uncertainties about the price of crude, not to mention worries about the strength of the global economy, make this no place to build a home.
Chet Needelman, of the California money manager Palley-Needelman, already has beaten a path out of energy shares. The firm had whittled down a 637,257-share position in Exxon Mobil to 53,388 shares as of June 30. Similarly, it cut a 974,725-share stake in British Petroleum to 39,988 shares, and pared a 94,996-share holding in Total Fina Elf, the French oil producer, to 24,949 shares. Needelman believes the global economy will remain weak at least through mid-2002.
"It's doubtful oil is going to stay at current levels or move somewhat higher," he says.
Crude recently was trading at $27.50 a barrel, down from last fall's peak of more than $37. But Thomson Financial/First Call reports that analysts have been marking down their estimates, and now expect prices to drop to $23.62 a barrel in 2002, and $22 in 2003.
Bear Stearns analyst Fred Leuffer thinks these subdued forecasts may be still too rosy. Last spring, he laid out a case for $18 oil, based on his assessment of changes in Saudi Arabia's oil policy. Leuffer notes that some refined products, such as gasoline and home heating oil, earlier this summer sold below the cost of the crude from which they were derived -- further tesimony to the market's view that oil prices are not sustainable at current levels.
Table: Running Out of Gas?
Another ominous sign of a probable drop in crude is the massive speculative short position in futures contracts that has built up on the New York Mercantile Exchange. Last month, net short positions climbed above 68,000 contracts (each of which equals 1,000 barrels of oil); two years ago, ahead of the sharp rally in crude, the so-called non-commercials, or non-industry traders, had a net long position of 100,000 contracts.
Any downward shift in petro prices is bound to be felt in company earnings and, ultimately, in energy shares. Indeed, Wall Street analysts have been slashing estimates for many companies on the heels of record quarterly profits. Take Chevron, which netted $1.32 billion, or $2.05 per diluted share, for the quarter, and is expected to earn $5 billion, or $7.81 a share, for the year. In late July, Goldman Sachs pared its forecast for Chevron's fiscal 2002 profits to $7.41 a share, from a prior $7.53. ABN Amro cut its outlook to $6.80 from $7, and A.G. Edwards nicked its estimate by a dime, to $6.30. The wide range of estimates attests to the confusion regarding oil prices on the Street.
Oil-sector earnings are likely to become a drag on S&P 500 profits in the current quarter, after many quarters of gains. In the fourth quarter, says First Call's Chuck Hill, analysts are looking for oil-company earnings to fall 26% from year-ago levels, versus a decline of just 0.4% in total S&P earnings.
Even as they slice their earnings forecasts, many Street seers maintain Buy ratings on oil shares and remain determinedly bullish about the sector's long-term prospects. But the stock market is rendering a notably different verdict. The S&P index of oil and gas producers currently sells for a price/earnings multiple of 15 times expected earnings for the next 12 months, or roughly 60% of the market multiple of 25. This suggests that investors also doubt that earnings growth will remain so strong. According to Bear Stearns' Leuffer, the major oils now trade as though the price of crude were $20-$22 a barrel.
Lower earnings are apt to make energy issues less attractive as defensive holdings, particularly if technology stocks perk up again next year. Consequently, Francois Trahan, an economist at Brown Brothers Harriman, has been recommending that investors lighten their exposure to stocks such as Exxon Mobil, Chevron and Phillips Petroleum. But he still likes Sunoco, an oil refiner, which is likely to be a beneficiary of lower crude.
George Gaspar, of Robert W. Baird in Milwaukee, also has grown more skeptical. In June he downgraded Exxon, Chevron and Phillips, in part because of a large buildup in weekly inventories of natural gas. Gas prices, which peaked around $10 per million British thermal units in December, have fallen much more precipitously than oil, but last week climbed about 40 cents, to $3.40 per mmBtu.
Gaspar is optimistic about the prospects for energy stocks over the longer term, because he expects an uptick in oil demand to translate into higher crude prices next year. The Organization of Petroleum Exporting Countries needs a higher price, he says, in order to develop more reserves.
Yet Leuffer argues that OPEC probably lacks the discipline to maintain prices around $25 a barrel, even though the international cartel has slashed its production targets by 3.5 million barrels a day this year. "We are surprised at how quick the market is to believe that OPEC will do what it says, even though the organization's recent record of quota compliance is so poor," he wrote in a recent report.
Notwithstanding his downbeat view, Leuffer has been recommending Royal Dutch, which owns 60% of Royal Dutch/Shell Group. Two years ago, the company centralized its diverse management system, concentrating financial operations in London and The Hague. This coordinated approach to cash management, he says, could bring Royal Dutch's valuation more in line with that of Exxon Mobil, which sells for 10 times enterprise value (market capitalization plus debt and preferred shares, minus cash and equivalents) to EBITDA (earnings before interest, taxes, depreciation and amortization). In addition, the company's earnings are the least sensitive, among the majors, to changes in oil prices, which would be a big plus if Leuffer's $18 forecast is borne out. Royal Dutch is trading for $56-$57 a share, well below Leuffer's target of $70.
Leuffer also has Buy ratings on Marathon Oil and Chevron, though he expects the latter to earn just $4.45 a share next year. But he pared his Buy on Amerada Hess after the company agreed to purchase Triton Energy for $3.2 billion, plus $500 million in assumed debt. "We think Hess is paying too much for Triton, which will erode the company's return on capital, and therefore the value of the stock," Leuffer says. Hess shares slipped as much as 10% since the July 10 announcement of the deal, but have recovered and now trade at 77.
In Leuffer's view, Hess' wrist-slapping represents a warning to other oil-company managers to keep their wallets shut. And that may be another reason why investors like Chet Needelman are exiting the sector. Thanks to last year's spike in oil prices, company coffers are brimming with more than $40 billion in cash. But history shows that the energy industry is prone to squandering fortunes on dubious drilling adventures and fault-ridden acquisitions. So any way you look at them, oil and gas shares are running on empty. |
