Fool's Gold in the Oil Patch

If there's one constant about commodity prices, it's that they have a nasty tendency to change. Looking at energy stocks right now, though, it appears that many investors are betting that oil will remain at a very high level for quite some time. It seems to me like that's a bet with poor odds of success.

At the end of the day, the laws of basic economics have not been repealed: High oil prices will eventually cause energy consumers to reduce their demand and/or producers to increase supply. Either of these trends would put pressure on oil prices, and one (or both) is certain to happen at some point--unless consumers are willing to pay an infinite amount for oil, or producers are willing to supply an infinite amount of oil. Neither of these scenarios seems all that likely.

The Energy Money Pit
Why should this matter to you, when energy stocks have done nothing but rise in the recent past, and the financial media is awash in stories about "permanent oil shocks," "oil super spikes," and "a secular bull market in energy"? Because at current prices, most energy stocks are unlikely to be great long-term investments.

In fact, many energy stocks are unlikely to be decent long-term investments at any price, because they fail to generate economic profits over an entire commodity cycle. A few do so consistently, like  Exxon (XOM), and these have been excellent long-term investments. But most simply destroy economic value year in and year out, which makes them suitable only for traders interested in jumping on the latest bandwagon.

Cost of Capital Versus Returns in the Oil Industry
		Average returns on invested capital*
Industry	Average cost of capital	2002 (oil $26/barrel)	2003 (oil $31/barrel)	2004 (oil $41/barrel)
Exploration & production (independent)	9.9%	5.4%	7.7%	11.9%
Exploration & production (integrated--majors)	9.5%	8.5%	12.1%	14.4%
Oil/gas services	10.0%	4.5%	3.8%	5.3%
Oil/gas products	10.1%	7.0%	3.7%	7.0%
Pipelines	9.3%	8.9%	8.6%	8.5%
* Morningstar estimates

As you can see, it's tough to make money in energy, once you account for how capital-intensive most energy companies are. Of course, there's significant variation within the sector: Pipelines stand out for their consistency, while oil-services firms are mired in a fiercely competitive business with high capital costs that practically prevents them from generating economic profits.

And although exploration and production companies can do well when oil prices spike, we estimate that the major integrated firms need oil prices in the high 20s per barrel to generate returns on capital that equal their cost of capital, while the independent E&P firms need oil prices in the mid-30s. In other words, all industry players aside from pipelines (which are only very mildly sensitive to energy prices) and the major integrated firms (which have the benefits of both scale and diversified operations) need oil prices to stay significantly above their long-run trend to generate economic profits.

Whither Oil Prices?
So, how likely is it that energy prices will remain far enough above their long-run average for a long enough time to change this value-destroying industry into a value-creating one? Not very, in our opinion. Although oil has averaged about $45 per barrel over the past year, the post-World War II average is around $20 (in real dollars), and even a "modern" average from 1980 through the present is only about $26. And even though OPEC--which accounts for about 40% of world production and more than 75% of world reserves--does not currently have an official price band in place, the trial balloons being floated by OPEC bigwigs have been in the mid-30s.

Given that OPEC still has significant influence on the world oil market, and Saudi Arabia and Kuwait are the only major producers with current spare capacity (Russia and Iraq have potential capacity as well, but not immediately), the cartel’s implicit desire for long-run prices to settle in much lower than they are today would seem to be worth taking into account. If oil prices stay too high for too long, oil demand will decrease--either through conservation, consumer substitution to other forms of energy, or slower economic growth. None of these scenarios benefits OPEC or any oil producer interested in maximizing the long-term value of its reserves.

In fact, it's possible that demand is already starting to slow. Growth in oil demand from China is projected by the International Energy Agency to slow from 21% in the first quarter of 2004 to 5% in the first quarter of 2005, and high gasoline prices might already be causing a demand response in U.S. consumers. (This is not a small deal, since U.S. drivers consume fully 11% of world oil production.) A recent Merrill Lynch report noted slowing gasoline consumption in California, which has the highest gas prices in the U.S. Intrigued, I downloaded data from the fantastic Energy Information Administration Web site to create the following chart, which plots the year-over-year change in demand for gas in California against the average retail price for a gallon at the pump. Although the data is quite noisy, notice that the spike in oil prices in early 2003 seems to have triggered an incipient decline in gas demand in California. It's also worth noting that both  General Motors (GM) and  Ford (F) recently reported declining sales for large SUVs, while smaller, more-efficient SUVs continued to sell reasonably well.

Whither Oil Stocks?
In any case, it's pointless to debate whether or not oil prices are headed south right now, since I'm sure someone could muster plenty of evidence that contradicts the anecdotal points I just made. The point is that buying oil stocks today means that you're betting on prices staying higher for a good deal longer than many of the world's major oil producers want them to be, and that seems like a low-percentage bet.

Of course, commodity markets don't correct instantly because it takes time for new production to come onstream and it takes time for consumers to change their demand patterns. So, when we value oil stocks, we assume that prices fade down slowly--over two years--to a midcycle level in the low-30s. Without getting into the gory details of our oil-price forecasting methodology, the upshot is that we're assuming that oil prices will average about $50 for 2005, average about $42 for 2006, and average $35 in 2007 before slowly climbing again at the long-term inflationary rate of 3.6%.

These fairly generous--in my opinion--assumptions yield the following average valuations for the energy stocks we cover:

Valuation Measurements in the Oil Industry
	Price/Morningstar fair value estimate*	Median forward P/E**
Industry	Median	High	Low
Exploration & production (independent)	1.20	1.90	0.90	11.01
Exploration & production (integrated--majors)	1.10	1.43	1.04	11.42
Oil/gas services	1.69	2.84	1.15	22.20
Oil/gas products	1.70	2.15	1.39	11.56
Pipelines	1.04	1.39	0.81	18.58
* 1.0 means the stock is fairly valued, in our view. A value above one indicates overvaluation, less than one indicates undervaluation ** Based on Wall Street consensus

Suffice it to say that we think the market is pricing in much higher oil prices than seem likely. In fact, we estimate that oil prices would need to stay above $40 for the next several years to justify the current trading prices of the average independent E&P stock. (That's to justify fair value, with no margin of safety.) The oil services group is even worse--most would need to grow 15% to 20% every year for the next five years, with operating margins running consistently at twice their 2004 levels, to justify the current stock prices.

Thanks very much, but we'll pass. Oil prices will slide eventually, and at that point--when everyone else is running for the hills and magazine covers are talking once again about an oil glut--we will happily recommend great little companies like  Cimarex ,  Ultra Petroleum ,  Pogo Producing , and some of the others listed here. In fact, we may not need to wait long. When oil prices slid down to the low 40s in late 2004, a few of our favorites almost got cheap enough to recommend. Even now, Pogo and  Apache (APA) would only need to fall about 14% to trade below our "consider buy" price, and even ExxonMobil would only need to pull back about 20%.

The time will come when some energy stocks offer an attractive margin of safety. Unfortunately, it doesn't look to us like that time is now.