Oil: High Prices, Cheap Stocks

Oil and natural gas stocks rank among this year's best performers, as rising energy prices have keyed better-than-expected earnings and lifted expectations for full-year 2004 and 2005. Yet amid the latest move to all-time highs in oil prices, energy stocks have slumped. Investors are concerned that higher oil energy prices will halt the world economy, reducing energy demand in 2005. Moreover, many are convinced that industry fundamentals do not support today's oil prices, that the move to all-time highs reflects speculation and fears of a disruption in supplies. The longer prices stay artificially high, argue the oil bears, the longer OPEC and others will produce at capacity--and the greater the risk of a hard landing for prices if fears of a supply disruption ease.

The world's oil producers have very little spare capacity, and the risk of a disruption in supplies from Russia or Iraq seems very real. Still, with U.S. inventories of crude oil and refined products in line with five-year averages, and 6% above last year's levels, oil prices are likely to fall unless supplies are disrupted. Natural gas prices, though likely to remain well above historical norms, have already retreated about 15% since June. With oil and gas prices more likely to fall than rise, should you be selling your energy stocks? While the group could pull back, having some energy exposure in your portfolio makes sense, for several reasons.

The stocks already reflect expectations of lower prices. According to Thomson First Call, the average Wall Street analyst expects the price of West Texas Intermediate crude oil to average $30.21 per barrel in 2005--well below the current price near $45. Profits for oil companies are expected to fall sharply in 2005, with predicted declines ranging from 15% to 40%. Energy stocks help to diversify a portfolio. If prices remain high through the winter, energy stocks are likely to deliver market-beating returns. Energy stocks represent 7% of S&P 500 Index's value, while Forbes' Buy List and Long-Term Buy List have about 11% in energy.

A return to $25 per barrel oil prices seems unlikely. The threat to the global economy seems overblown, as energy prices are well below previous highs when adjusted for inflation. With energy demand growth likely to remain healthy, expectations for 2005 pricing and oil-industry profits seem more likely to rise than fall. Also, energy stocks are reasonably valued. Several quality energy stocks are trading at attractive valuations relative to historical norms.

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Foresight analyst sees high potential in gas-to-liquids technology

Gas-to-liquids technology is "the ideal fuel to fill the widening wedge between rising world oil demand and falling legacy production," said Bernard J. Picchi, senior managing director of Foresight Research Solutions Inc., New York. GTL unit capital costs have come down, while oil and gas prices have spiraled in the last 2 years, he noted.

Picchi called GTL "the most promising current alternative to conventional oil production and refining. We liken GTL's current situation to that of LNG in the early 1970s: an exotic hydrocarbon processing technology not taken too seriously then. It won't take 30 years for GTL to achieve the prominence that LNG enjoys today."
GTL will be needed among many new fuels and energy technologies required to fill a growing gap between escalating world oil demand and falling oil production, he said.

"GTL project economics are healthy even if GTL products—mostly distillates like zero-sulfur diesel fuel—were priced off $25/bbl crude oil," on the New York Mercantile Exchange, Picchi said. GTL projects with output capacities totaling about 800,000 b/d have been announced within 18 months. In July, ExxonMobil Corp. announced plans to spend $7 billion on a 166,000 b/d integrated GTL facility in Qatar (OGJ Online, July 14, 2004). Other GTL players include Sasol Ltd., Shell International Gas Ltd., and ChevronTexaco Corp.

"It is the first inning of GTL's commercial life," Picchi said. "Many more facilities are likely to be built. GTL, now a distant cloud on the horizon, is likely to come into sharp focus quickly. This may not be a welcome sight for oil refiners." GTL plants, which convert natural gas to finished oil products including diesel and naphtha, are poised to release an abundant supply of fuel products in the next decade, he said.

"Unlike traditional refineries, GTL plants lock in their raw material costs—natural gas—for decades at prices 90-95% below the current market value of crude oil," Picchi said. "No oil refinery could compete against such a cost advantage. Further, once the high capital cost of building a GTL unit has been sunk, the facility will operate at the highest possible utilization rate under almost all oil price scenarios because GTL cash operating costs are expected to be low—about $10/bbl, we estimate."

S&P says it has positive view of Shell's structural overhaul

Ratings agency Standard & Poor's said Wednesday it viewed positively the proposed overhaul of Shell's complicated corporate structure outlined by the company last week. Shell said it planned to create a "one company, one board, one CEO" structure after almost 100 years of being governed by joint parent companies in the UK and the Netherlands. The plans, which still need to be approved by shareholders at annual meetings next year, will reduce the"governance-related concerns" S&P voiced in its latest credit review andseparate governance assessment of Shell in July this year. The proposed new structure could simplify decision-making, create direct lines of communicationbetween management and non-executive directors and enhance independentoversight, S&P said. The agency cut its long-term credit rating on Shell in April this year to "AA+" from "AAA" after successive downgrades to thecompany's proved oil and gas reserve base.The structural changes planned by Shell are expected to address the issues regarding complexity, opacity and lack of accountability that S&P believes contributed to the reserves debacle. But although the shake-up is likely to improve Shell's corporate governance, in the short term the company could see its credit rating cut further, the agency said. In addition to announcing its plans to change the company's structure, Shell last week also warned that a further restatement of reserves was possible, a move which prompted S&P to put the company's "AA+" rating on negative credit watch.

Is Oil Heading For $100?

What is the scenario in which oil hits $100 per barrel in the next five or six years?

Just as the current price increases are said to be fueled in part by rising demand from China and India, those countries will also play a large role in the long term. Stephen Leeb, president of Leeb Capital Management, a New York investment manager and author of The Oil Factor, says that China and India now consume energy (not just oil, but all forms of power) at a per capita rate that is one half the world average. Compared to the rich nations like the U.S. and Western Europe, their per capita consumption is one-seventh as large. If these two countries become wealthy, as everyone expects they will, and merely start to consume like the rest of the world (forget about their consuming like the U.S.), that rise in demand will have a dramatic impact on world energy markets.

Leeb estimates that if China and India continue to grow, the demand for oil will rise by 6.1% per year. To meet such demand, the world would have to raise output by 43% by 2010 and to triple it in 20 years.

Leeb says that during the last oil crisis, the world was producing at 70% capacity. Now it's at 99%. Because there is no slack in the system, every time there is a trial in Russia, a strike in Venezuela, a hurricane off Louisiana or a surge in violence in the Middle East, the oil markets react dramatically. The good news is that we are more efficient than in the 1980s, and we spend a much smaller share of gross domestic product on energy. But while demand may slack off short term due to slower growth, the longer term is troubling regardless of new production technology or far better conservation.

Where have we heard this before? In the 1970s and 1980s, some prognosticators spoke about the world "running out of oil." That prospect is not what drives the current fears. It is the apparently inevitable supply-and-demand driven market movements that may force the price of oil to $100. And that's a lot scarier.