Tuesday, October 24, 2006

Short Attention Span

Suddenly the newspapers are filled with articles on the challenge facing major oil companies in sustaining quarter-on-quarter earnings gains, in light of stalled or falling oil prices. Rather than viewing this as some sort of deep market wisdom, we should see it as a reminder of how fickle market psychology can be. Just as momentum traders have seen the breakdown of the trends that impelled them to pile more and more assets into the energy sector, a wider group of investors is beginning to realize that oil might not hit $100/barrel this year, and that, as an Associated Press headline suggests, the "Oil Patch's Profit Party Is Slowing Down." What is the average shareholder to make of all this, and does it have any bearing on the future price of gasoline?

Oil companies have had an amazing run of profit growth, fueled by the steady increases in oil prices. It's hard to believe that five years ago this week, oil was trading on the New York Mercantile Exchange for $22/bbl, and three years ago it was still only $30. Sooner or later, prices were bound to correct, and when they did, the key earnings-growth engine that these companies have relied on recently would falter. And as many commentators have pointed out, not only are prices not going up, but companies are being caught in a margin squeeze, as the costs of the hardware and services they buy to operate in the exploration and production business continue to inflate. This will put pressure on producer profits in the near future, and the scope for other cost reductions is limited, because most of these companies started pretty lean, and few of them expanded dramatically while the good times rolled.

Although much of this rings true, it ignores some fundamental realities of the business. Equity analysts have generally been conservative in the future prices they've used to value the oil sector. That means that the stock prices of the majors and independents weren't reflecting $80 oil, even at the peak of the market this summer. If they had been, ExxonMobil wouldn't be trading at $70; it would be closer to $90. Likewise for Chevron, ConocoPhillips, etc. With current prices below $60/bbl, but the long-term end of the market still well over that, we're probably in the range that most of the analysts were using, anyway. So the question is not one of over-valuation, but of the magnitude of any further upside.

The other issue here is access to commodity price exposure. Although the stock prices of oil companies are certainly sensitive to the price of the commodity--though to widely varying degrees--the proliferation of market instruments and the growth in investor sophistication have reached a point at which no one needs to buy or sell oil equities to go long or short on oil. Investors can use funds, futures or options that do this directly, and that's been true for some time. So if, as someone told me many years ago, every oil company share is essentially composed of a piece of a giant cash machine plus an embedded option on the future price of oil, it's a pretty expensive way to buy that option. Even if the hedge funds unwind all their oil positions, that shouldn't translate into a dollar-for-dollar decline in oil equity prices.

Having owned oil company shares for most of my adult life, either as a byproduct of employment or as part of my retirement plan, I have become pretty sanguine about their ups and downs. But when I look at the big picture, which includes an unstable Middle East and pre-nuclear Iran, restricted access to more than half the world's remaining oil reserves, and the non-zero probability of an impending peak in global oil production, then these companies still look pretty solid, regardless of their ability to beat this quarter's results next quarter. If the intrinsic value of XOM, CVX, COP and their brethren isn't now a solid multiple of what it was when oil was at $22/bbl, I'll eat my hat.

As to gasoline prices, I don't see any influence from the price of these equities. We should enjoy life near $2.00/gallon but not count on this lasting. That's not because oil companies will try to boost sagging earnings by inflating pump prices; they don't have the power to do that in a market that is more competitive than that for almost anything else that consumers buy. Eventually, though, there'll be another spike in Mideast tensions, or terrorism, or a supply disruption. And if there's not, a new Congress might just find higher gasoline taxes irresistible, either as a consequence of addressing global warming, or as part of a plan to improve our energy security. That could depress the long-term value of oil companies more than anything else I've mentioned today.

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