Oil stocks lag behind oil prices

4/28/2008


The price of oil has jumped nearly 70% since August, when prices dipped below $70, while natural-gas prices have rallied more than 80%. But energy stocks have not kept pace, as the S&P 1500 Energy Sector Index is up just 20% since the end of August. Among the industry groups within the energy sector, only the independent exploration and coal companies have delivered gains commensurate with commodity prices.

Several factors have hurt the performance of energy stocks.

  • Large oil producers are having a difficult time replacing reserves. The nationalization of overseas oil fields has hindered big oil’s quest to find new reserves. In addition, the need to explore deeper water has increased exploration costs.
  • Some energy companies have had difficulty translating high per-barrel oil prices into improved profits. High crude prices increase costs at the refining and chemical businesses operated by many integrated oil companies.
  • Wall Street focuses on the future, and there seems to be a consensus that a more subdued economy will crimp oil demand and send prices lower. Lower oil prices could slow drilling activity and reduce demand for oilfield supplies and services.
  • Integrated oil companies are hampered by poor margins on their refining operations. The S&P 1500 Integrated Oil & Gas Industry Index is up just 12% since the end of August and roughly flat so far this year. The refining index is down 28% this year.

The Forecasts continues to see opportunities in select oil stocks. Among oil producers, Chevron ($94; NYSE: CVX) and Exxon Mobil ($94; NYSE: XOM) remain our favorites.

While declines in oil and natural-gas prices over the next year would not be a surprise, the Forecasts expects prices to remain well above historical norms, high enough to support strong drilling activity. We are particularly bullish on such oilfield-services companies as National Oilwell Varco ($74; NYSE: NOV), Oceaneering International ($69; NYSE: OII), and Transocean ($158; NYSE: RIG).

Two top energy picks are reviewed in the following paragraphs.

Exxon Mobil ($94; NYSE: XOM) shares fell after the company said it would increase 2008 capital expenditures by roughly 25%, yet production would fall slightly. Half of the spending increase is due to cost inflation, with another quarter related to project delays. That leaves only one-fourth of the increase to fund new projects.

Yet, there are reasons to think Exxon will benefit from the high price of oil. So far this year, Exxon shares are up 1%, one of the better performances among the oil supermajors. Exploration and production accounted for 65% of profits last year, and the company has 12 major projects on schedule to start producing this year. While profit margins for U.S. refining and marketing are small and shrinking, U.S. refining and marketing provided just 10% of profits last year and should decline further as a percentage of profits in 2008.

Proved oil and gas reserves declined 3% last year, and production fell 1%. But Exxon replaced 130% of its reserves from 2004 to 2006, and with a dozen production startups this year and seven more scheduled for 2009, Exxon should be able to regain some of the lost ground. Exxon Mobil is a Long-Term Buy.


Oceaneering International ($69; NYSE: OII) is a key player in deepwater oil exploration. The amount of oil these deepwater fields produce is expected to double between 2005 and 2010 because energy producers are moving increasingly far from shore as more convenient fields mature. Deepwater-production spending could reach $25 billion in 2012, twice the level seen in 2003.

The Oceaneering segment benefiting most directly from the boom in deepwater oil is remotely operated vehicles (30% of 2007 revenue). The company’s 210 underwater vessels are commanding rental rates of about $8,750 per day, up 16% from a year ago. Oceaneering plans to add 30 new vehicles this year.

The subsea-projects unit (15% of 2007 revenue), which performs underwater work, is also benefiting from the industry’s expansion. Operating margins reached 35.9% in the December quarter, up from 30.9% in the year-earlier period. Oeaneering has pulled back 20% from October highs and now trades at 19 times expected 2008 earnings, a reasonable price for a company that seems capable of annualized profit growth of more than 15% over the next three years. Oceaneering, a Focus List Buy, is slated to release March-quarter earnings April 30.


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