High-Octane Plays at Regular Prices
By A. BARY
The sharp drop in oil and natural-gas prices has produced an even sharper pullback in energy stocks, creating what may be one of the best buying opportunities in the sector in several years.
THE SHARP DROP IN OIL AND NATURAL-GAS PRICES HAS produced an even sharper pullback in energy stocks, creating what may be one of the best buying opportunities in the sector in several years.
Energy issues have rarely been so inexpensive, relative to oil and gas prices, estimated asset values and earnings. Barring a collapse in oil and gas, energy could prove to be one of the market's top groups over the next year. Most of the stocks could easily rise 25% or more.
Justin Sullivan/Newscom
Even though gasoline prices have slipped from where they were when this picture was taken a few weeks ago, they're likely to remain high.
It's hard to find a sizable energy company that's trading for more than 10 times next year's estimated earnings. As the table below shows, the major oils -- ExxonMobil (ticker: XOM), Chevron (CVX), BP (BP) and ConocoPhillips (COP) -- now fetch five to seven times next year's projected profits. The majors have rarely had such low price/earnings ratios.
The projected 2009 profit estimates could prove too high, of course, given the 22% drop in oil prices to $115 a barrel from a peak of $147 on July 11. Natural gas has fallen even more sharply, declining 35% to $8.50 per million BTUs from a July high of over $13.
The stocks, however, seem to be discounting a drop in oil to well below $100 a barrel, and a skid in gas to as low as $6 per million BTUs. Energy shares have badly trailed commodity prices. The XLE (XLE) -- the exchange-traded fund for the S&P 500's energy issues -- is up just 6% over the past year, while oil has risen 66%.
Investors have several ways to play energy, including the major international oils, independent domestic producers and Canadian energy outfits.
"THIS HAS BEEN ONE OF THE SHARPEST CORRECTIONS ever in E&P," says David Kistler, an energy analyst at Houston-based Simmons & Co., which focuses on independent North American energy and production stocks. "Nearly every stock screens with tremendous valuation upside." Simmons estimates that major independents like Anadarko Petroleum (APC), Devon Energy (DVN) and XTO Energy (XTO) now trade at little more than half their net asset values. Kistler views the independents' risk/reward ratio as excellent.
The independents benefit from growing production bases heavily tilted toward North America, shielding them from Venezuelan-style expropriation, Russian strong-arming and the general shift in the balance of power to host countries and state-owned companies. This is one reason that the market has awarded higher P/Es to the independents than to the majors.
Kistler says that investors fear further stock-price declines if there is permanent "demand destruction" in the U.S., in reaction to high fuel costs.
Independents like Anadarko, Devon Energy and XTO have come down hard because they get most or nearly all their revenue from natural gas, which could be more vulnerable than oil, thanks to rising domestic production. There's no way to export sizable amounts of gas, so high production can slam prices. Kistler says the stocks should rally if oil and gas prices hold at current levels.
It's probably cheaper to buy energy reserves on the New York Stock Exchange than to drill for them, given sharply higher finding costs and the risks of dry holes. This could prompt a new wave of takeovers if the independents' share prices don't bounce back.
Anadarko and Devon are viewed as prime targets. Anadarko, which has grown through acquisitions, is considered receptive to a takeover. And Devon, headed by longtime CEO Larry Nichols, 66, finally may be willing to deal. XTO is viewed as an unlikely seller because CEO Bob Simpson, 60, seems intent on creating the largest domestic natural-gas producer.
THE MAJORS BECKON, given their low P/Es, strong balance sheets and diversified business mixes that involve energy production, refining and chemicals. Exxon has $30 billion in net cash (cash less debt) and is likely to produce almost $50 billion of after-tax profit this year. One potential plus for the majors next year is that refining margins, which have collapsed, could reverse.
A legitimate knock on the U.S. majors is that they're stingy with dividends, paying out just a fraction of their profits and opting instead to earmark much of their earnings for stock buybacks that have done little for their share prices or valuations. Exxon and Conoco yield just 2%; Chevron, 3%. Exxon may buy back $35 billion of stock this year, while paying out $8 billion in dividends. The overly conservative U.S. majors could easily offer 5% dividends and still have ample funds for buybacks. European oil giants like BP and Royal Dutch Shell (RDS-A) have payouts in the 4% to 5% range.
Table: Nothing to Gush OverWhat's ailing the major oils? Exxon grabbed headlines with its second-quarter after-tax profits of $11 billion, a record for any company. Its earnings were deemed obscene by those in Washington who want to revive the 1970s-era windfall profits taxes. Exxon's earnings, however, didn't play as well on Wall Street; analysts noted that they trailed the consensus estimate for the second straight quarter and that Exxon's energy production had fallen 8%.
Some one-time factors hurt Exxon, the largest and best-managed major oil, but even a generous assessment of its production showed a 2% drop. Exxon and Chevron are being hurt by so-called production-sharing agreements with the governments of the foreign lands from which they pump oil and gas.
These largely undisclosed accords, involving nations such as Angola, typically limit the Western oil companies' returns and production after their initial investments are recouped. Given high oil prices, these agreements are quickly putting the host countries in the driver's seat. In a recent research note, Oppenheimer analyst Fadel Gheit wrote that "high oil prices are not good for Exxon's business as they increase government take in royalties and taxes, strengthen national oil companies, limit access to resources, but, above all, depress the share price." Gheit may exaggerate the impact; only about 20% of Exxon's output is subject to production-sharing agreements, and the company did enjoy a sharp rise in second-quarter earnings. In any case, the problems seem well-discounted in Exxon's share price.
Still, the overriding fear in the investment community is that the international oil giants will have a tough time maintaining production levels, given less-favorable international operating conditions. At current valuations, they're being treated like wasting assets.
Paul Cheng, Lehman Brothers' energy analyst, is a fan of Chevron because of its low valuation. It recently was trading at 83, just 6.6 times projected 2008 profits of $12.70 a share. Cheng expects the company to be able to boost output by 4% in 2009 and 2010, according to a recent note. Wall Street seems wary of Chevron because much of its production growth is coming from potential trouble spots overseas, including Nigeria, Kazakhstan and Angola. Conoco, whose shares, at 80, trade at a rock-bottom six times projected 2008 earnings, has less international exposure than Chevron and Exxon, but that hasn't helped its valuation.
The Bottom Line
Based on the major energy companies' prospects and valuations, their shares are trading at levels that make them look like bargains for long-term investors.Canadian energy producers also have fallen sharply, including oil-sands operators like Suncor (SU) and Canadian Natural Resources (CNQ).
Shares of Suncor, the most prominent oil-sands play, have slid to about 50 from 74 in May, hurt by lower crude prices and disappointing production. But Suncor's daily output should rise sharply in the next year, and its shares now are at a reasonable 8.5 times next year's estimated earnings. In recent years, Suncor has consistently traded at a P/E premium to other major oil companies because it has enormous reserves that may last a century, against the 10 to 20 years for the major international oils. This is a huge advantage.
Among U.S. independents, XTO has been particularly hard hit on Wall Street, with its stock tumbling to the mid-40s from a June peak of 73, as investors fret over declining gas prices and the company's $10 billion acquisition spree this year. But over the past 22 years under Simpson's leadership, XTO has become a leading U.S. natural-gas producer, with excellent drilling results, low finding costs and shrewd acquisitions.
At a recent 45, XTO was valued at 10 times projected 2008 profits and at less than $2.50 per thousand cubic feet of reserves. The company has long traded at a premium to its peers, based on earnings, cash flow and reserves, but that premium has disappeared.
Given such valuations, it seems tough to go wrong now with XTO or almost any major energy stock, even if energy prices fall a little further.
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