Run-up in oil stocks tempting investors

Opportunities exist, but experts warn market can be volatile

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September 11, 2005|By Leon Lazaroff | Leon Lazaroff,CHICAGO TRIBUNE

Before Hurricane Katrina ravaged the Gulf Coast, Wall Street was warning that oil stock prices were getting high. Investors were urged to be cautious.

As the price of crude oil jumped during the past year, to about $70 a barrel, oil stocks surged. Since September 2004, the American Stock Exchange's index of integrated oil companies, a basket of 12 mostly large producers, is up 68 percent.

Some companies' stocks have done far better. Shares of Valero Energy Corp., a refiner, have climbed by more than 150 percent this year; Halliburton Co., the world's largest oil-services company, is up more than 68 percent.

Those sorts of run-ups had many investors wondering whether shares have peaked.

But Katrina's battering of Gulf Coast oil infrastructure - refineries, pipelines, ports - came at a time when most refineries already were operating at full throttle, overloaded with unprocessed crude. Now, experts said, oil prices are likely to stay above $60 a barrel longer than Wall Street was expecting.

Katrina might have been horrific, and high oil prices are no bargain for consumers, but they're good news for oil companies and their investors.

Marc Pado, U.S. market strategist at Cantor Fitzgerald, says a lot of speculative money - hedge funds, for example - have been bidding up refinery, drilling and oil-services stocks. Quick on the draw, these funds are taking advantage of the uncertainty Katrina has cast over the entire industry.

As a result, shares in services giant Schlumberger Ltd., driller GlobalSantaFe Corp., and the refining company Devon Energy Corp. have posted gains.

But oil stocks move in a very volatile market.

Although shares showed little effect from last week's drop in crude prices, few sectors are as tied to the fortunes of one metric as oil stocks. That means a sudden, lasting downturn in the price of crude is likely to spark a binge of selling.

"Once demand for gasoline slows, there'll be a corrective move for oil stocks that will probably be sharp and defy company valuations," Pado said, adding that hedge funds and other aggressive market players will be taking profits.

For average investors, who dutifully watch revenue and earnings numbers, such a sudden move lower is bound to drive them crazy. Earnings growth might be solid, but markets don't always act rationally.

Nonetheless, the recent run-up in oil stocks has many investors eager for a way in. David Dropsey, a research analyst at Thomson Financial, said the relatively inexpensive price of some oil stocks makes them tempting.

Valero, for instance, trades at 11 times its forward price-to-earnings ratio, while the major integrated oil giant ConocoPhillips trades at a forward ratio of 8. Anadarko Petroleum Corp., an oil producer rumored to be a takeover target, trades at a forward ratio of just over 9.

"These companies don't need the price to go up to earn money," Dropsey said.

Gasoline prices, though, cut both ways. Higher prices boost revenue, but there's a tipping point at which high prices stifle demand. At present, gasoline demand doesn't appear to be weakening. But Pado says that could change in a hurry if $3 a gallon becomes the norm.

If gas prices stay that high, Pado said, consumer spending will drop. For a national economy in which roughly two-thirds is driven by consumer spending, the repercussions of high gas prices would extend beyond oil stocks.

Mix in the end of low-interest financing and the possibility that housing prices have peaked, and the stock market could be in for a much flatter 2006 than some anticipate.

Ajay Mehra, portfolio manager at Columbus Nova, a New York private equity firm, warns that once crude prices peak, stocks historically move backward.

"We'd be cautious getting into oil right now," Mehra said. "These stocks aren't expensive, but when they fall, they'll fall regardless of earnings."

Phil Dodge, energy research analyst for Stanford Group Co., acknowledges sector volatility but argues that regardless of crude pricing, drilling and equipment companies are likely to do very well.

Dodge said the major integrated oil companies are sitting on a lot of cash. From 2000 through 2004, Chevron, Exxon Mobil and BP spent comparatively very little of their profits on new projects, preferring to pay down debt and buy back stock. Over the medium term, Dodge foresees capital expenditures growing annually 10 to 15 percent.

"Deep-water projects are much less saturated," he said. "Even as crude prices drop, the majors still have to spend money to find and maintain their supplies."

But the integrated producers are likely to move with the price of crude. In other words, when prices come down, shares of the so-called majors are likely to come down, too.

But in the longer term, Mehra likes the integrated firms, basing his outlook on world demand.

Mehra says standards of living are rising in countries such as India, which has a middle class long on aspirations. More foreign investment has meant more demand for energy. India and China account for nearly 50 percent of the world's population.

"The demand and growth in these economies hasn't come close to peaking," he says. "Where will all this energy come from?"

The Chicago Tribune is a Tribune Publishing newspaper.

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