Time to bet on oil again

The collapse in the price of crude has caused companies to slash budgets - setting the stage for a rebound that should propel stocks higher.

EMAIL  |   PRINT  |   SHARE  |   RSS
google my aol my msn my yahoo! netvibes
Paste this link into your favorite RSS desktop reader
See all CNNMoney.com RSS FEEDS (close)
By Mina Kimes, reporter

(Fortune Magazine) -- Ever since crude hit a record high of $147 per barrel last July, owning oil stocks has been a little like bungee jumping - a long, terrifying plunge that you pray will be followed by a life-affirming bounce. Well, it may finally be time to exhale.

With oil rebounding to more than $50 for the first time since November, there is a growing consensus among industry analysts and investors that the stage is set for a multiyear rally that will propel stocks higher. "The question is not if, but 'How fast? How much?'" says longtime Oppenheimer analyst Fadel Gheit.

Given the fact that the current economic downturn is both more severe than any in decades and global in its reach, it might seem counterintuitive to be bullish on oil prices. Indeed, worldwide demand will sink 1.6% this year, according to the Energy Information Administration. That means that our oil-thirsty society is in the rare position of having excess capacity on its hands - hardly a price-booster in the short run.

But while consumption is trending down, analysts are projecting that supply will fall even further in the years ahead. In a report called "The Long Aftershock," oil industry consultancy Cambridge Energy Research Associates (CERA) recently warned that production might reach only 101.4 million barrels a day by 2014 - or some 7.6 million barrels less than it projected last fall.

"We're seeing the impact of the worst recession since the Great Depression on oil," says Daniel Yergin, co-founder of CERA. "A significant part of the supply that was anticipated to come onstream is now at serious risk." (For more from Yergin, see Q&A below.)

The dropoff in future supply can be directly tied to last fall's plummeting prices. OPEC, desperate to keep oil above $50 per barrel, has been decreasing its output with a goal of cutting 4.2 million barrels a day from its members' daily production. Meanwhile, virtually every major independent oil company has been slashing exploration budgets and slamming the brakes on new projects. According to analyst Paul Cheng of Barclays Capital, the nine large integrated oil companies he covers have cut a total of $36 billion of planned capital expenditures over the past six months. All of which means that when demand does rebound, supplies will be hard pressed to keep up - creating the conditions for another surge. "The most important driver for oil stocks is oil prices, which bottomed in January," says Cheng. "We like the sector for the next few years."

There are other reasons to favor the oil sector right now. For one thing, it's attractively valued compared with the broader market. The Amex oil index currently trades at six times its earnings for the past 12 months and has a dividend yield of 4%, compared with the S&P 500's price/earnings ratio of 12 and 3.5% yield. Putting some money into oil producers also makes sense if you're worried about the impact of the government's efforts to revive the economy. Washington is spending trillions of dollars to bail out banks and stimulate spending. That could eventually drive down the value of the dollar - and boost inflation. Because oil is traded in dollars, a weaker U.S. currency puts particular pressure on the price of oil, as foreign sellers demand more greenbacks for their crude. So while you may be paying more for gasoline and heating oil may rise, at least your oil stocks will go up too.

How to play an oil surge

One tried-and-true approach to betting on oil is to buy the biggest, most stable company in the sector. That, of course, is Exxon Mobil (XOM, Fortune 500), which, with $477 billion in revenues, is by far the largest of the supermajors and has the best return on equity. But many oil investors aren't wild about the stock at its current price. While Exxon is the largest holding in T. Rowe Price's $2.9 billion commodity-focused New Era Fund, manager Charles Ober says the stock, though ultrasafe, isn't worth its premium over its peers. Exxon has a P/E ratio of 8, the highest of the majors. Plus, Exxon's very size and stability mean that it probably won't rise as much as its smaller rivals if there's a strong move up in crude. "Right now, I'd rather have something that's more levered to the price of oil," says Ober.

Where should you look beyond Exxon? With future capacity in short supply, the best way to pick winners, analysts say, is to focus on the few companies that are positioned to sharply increase production. And among the oil giants, the company with the brightest outlook is Chevron (CVX, Fortune 500). Barclays estimates that Chevron will increase production by 2.7% annually through 2012, the best rate among the super majors. "Right now, Chevron has more resource opportunity than they've had in a long time," says J.P. Morgan analyst Michael LaMotte, who expects the company to work deals to get access to new reserves in countries like Iraq and Brazil. With a P/E of 6, Chevron is also cheaper than Exxon, and its dividend yield of 3.8% is nearly twice that of its bigger rival.

A pair of mid-majors also offer robust growth prospects. According to Barclays, Hess (HES, Fortune 500) will increase its production capacity by an average of 2.4% a year through 2012. But J.P. Morgan's LaMotte believes the company's holdings in Brazil and West Africa give it the potential to far surpass that estimate. "When you look at exploration upside, Hess has considerably more than any other company," he says. Marathon Oil (MRO, Fortune 500), which Barclays expects to boost production by a robust 4.3% this year, is a particular favorite of Ed Maran, the manager of the $2.1 billion Thornburg Value Fund. "It's trading far too cheap relative to the value of its assets," says Maran.

But perhaps the most impressive growth story in the oil world belongs to Petróleo Brasileiro (PBR), or Petrobras, the giant Brazilian oil company based in Rio de Janeiro. Over the past two years the company has announced three deepwater discoveries that are potential mega-fields. While they'll take years to develop, they have vast potential. "If you look across all the companies you can buy as an oil investor, there's only a handful of companies that can grow organically, and we like Petrobras the most," says Cheng of Barclays. He also points out that while new investors have flocked to the company's common stock, they have largely ignored its preferred shares, which currently trade at a significant discount. If you're going to play the oil rebound, you might as well start from the lowest point possible.

Q&A: Daniel Yergin

Are we soon headed for $200-plus oil? Daniel Yergin, chairman of Cambridge Energy Research Associates, doesn't think so. But CERA recently warned that massive cutbacks in production, driven by the global slowdown, could severely cramp the growth of the world's oil supply - leading to a 7.6-million-barrel-a-day shortfall by 2014. Yergin, author of "The Prize," a Pulitzer-winning history of oil, answers Fortune's questions about what's next for crude.

Why are you lowering your oil supply projections?

After this extraordinary collapse, everyone has had to go back and reprioritize. Projects further out have been postponed - items like deepwater exploration, wildcatting, and unconventional oil. These bigger, more expensive projects are being pulled back. That's how we could lose 7.6 million barrels a day.

Will consumption bounce back to what it was?

The U.S. reached peak demand, in terms of gasoline consumption, in 2007. Now we're looking at flat or declining demand into the future here. There's an increasing emphasis on energy efficiency, and climate change is becoming the driver of policy. But the world is divided between emerging and industrial countries. Since 1980, oil demand in the industrial world has gone up 20%, and in emerging markets it's gone up 40%. That's where the future is in terms of growth and oil demand.

Are we headed back to $147 oil?

If at-risk investment doesn't happen and we get a strong surge in demand on the back of an economic recovery, then we could be back to a higher-price environment. But I think this time, when we start to see prices go up again there will be a greater sense of contingency. During the run-up, financial markets were deeply engaged in oil prices. There was an overpowering sense that this time was different, prices will go up forever, it won't affect demand. Now, in the energy markets, as everywhere else, there will be a greater emphasis on prudence. To top of page

Company Price Change % Change
Ford Motor Co 8.29 0.05 0.61%
Advanced Micro Devic... 54.59 0.70 1.30%
Cisco Systems Inc 47.49 -2.44 -4.89%
General Electric Co 13.00 -0.16 -1.22%
Kraft Heinz Co 27.84 -2.20 -7.32%
Data as of 2:44pm ET
Index Last Change % Change
Dow 32,627.97 -234.33 -0.71%
Nasdaq 13,215.24 99.07 0.76%
S&P 500 3,913.10 -2.36 -0.06%
Treasuries 1.73 0.00 0.12%
Data as of 6:29am ET
More Galleries
10 of the most luxurious airline amenity kits When it comes to in-flight pampering, the amenity kits offered by these 10 airlines are the ultimate in luxury More
7 startups that want to improve your mental health From a text therapy platform to apps that push you reminders to breathe, these self-care startups offer help on a daily basis or in times of need. More
5 radical technologies that will change how you get to work From Uber's flying cars to the Hyperloop, these are some of the neatest transportation concepts in the works today. More
Worry about the hackers you don't know 
Crime syndicates and government organizations pose a much greater cyber threat than renegade hacker groups like Anonymous. Play
GE CEO: Bringing jobs back to the U.S. 
Jeff Immelt says the U.S. is a cost competitive market for advanced manufacturing and that GE is bringing jobs back from Mexico. Play
Hamster wheel and wedgie-powered transit 
Red Bull Creation challenges hackers and engineers to invent new modes of transportation. Play

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.