“It was started off this morning, when British Petroleum came out with the earnings and dropped over 53% from last year and they basically said, hey, guys, I know that oil prices have been excited about increasing demand, but you know, up to this point, we’ve seen little evidence of that…” Fox Business 7/28/2009

The oil industry got its first peak under the hood of the major integrated oil firms when BP (BP) reported earnings Tuesday, with Exxon (XOM) and Chevron (CVX) on deck later this week.  BP was able to report earnings of $1.40 per share which exceeds analysts estimates of $.92 per share.  Profits are down 53% from the period a year ago, much of which is attributable to the lower price for oil in the world market.  The company was able to exceed earnings estimates in this challenging environment because of a sustained drive to cut costs over the last few years.  It remains to be seen how much the other majors could cut their costs, but the lower oil prices compared to a year ago should make the second quarters’ results look drastically worse.

BP stock fell about 2.6% on Tuesday after the CEO, Tony Hayward, issued a rather sober outlook for the return of oil demand.  The rebound of equities and the stabilization of macroeconomic data has fanned hopes that economic growth is around the corner.  This has brought oil prices back to the mid-$60’s.  Hayward said, “The overall picture is of energy demand now stabilizing following significant falls in the first half of the year…We see little evidence of any growth in demand and expect the recovery to be long and drawn out.”

BP dismissed the premise that economic growth has begun to invigorate demand for energy.   Hayward was careful not to sound optimistic about the near term prospects for oil prices, and he makes the case than when demand does recover it will be “long and drawn out.”  Not surprisingly, oil prices were down today with this outlook in mind.  BP also reported that production was up about 4% on the quarter, which could add fuel to speculation to the bearish side that overproduction will crater oil prices. 

From our view BP did perform well in the quarter, as they had to contend with drastically lower oil prices.  We have viewed BP as Undervalued for quite some time, and the fundamentals of the company are still fairly strong.  Some have speculated that BP’s dividend of $.84 per quarter would be under pressure with oil prices below $80, but they held the dividend at that high level.  The average oil price per barrel this quarter was $52.33 this quarter and the company still had no trouble covering its dividend, so we think barring another huge drop in oil BP will be able to sustain this hefty yield.  This yield of close to 7% should be attractive to income investors.

We think that BP is attractively priced at or below $50, and according to our methodology BP could reasonable fetch $63-$72 range based on current fundamentals.  At the current price level, BP is priced well below its historical price-to-cash earnings range of 6.2x to 8.9x, currently BP trades for under 5x cash earnings.  The stock is similarly below its price-to-sales historically normal range, as well.  Of course, there is a risk in oil stocks right now as demand appears to be weak, but at this price long term oil bulls can afford to be bullish on BP as well.

OPEC oil ministers decided for the third meeting in a row to lower the daily oil production quota coming from the 12 member cartel. The 2.2 million barrel per day cut is the largest pledged decline in OPEC history in the face of crude oil prices that have fallen more than 70% from record highs this summer. This brings the cartel’s combined production cuts to about 4.2 million bpd. The obvious goal of member countries is to shrink global supply and thus stem the plunge in oil prices. OPEC, which produces about one-third of the world’s oil supplies, normally moves the market with such announcements, but oil is down about five percent today.

OPEC member countries are losing money hand-over-fist as prices continue their free-fall. Furthermore, there is a substantial supply glut in the system, so much so that crude oil is being stored in tankers at sea because there is no place to deliver the product. Saudi Arabia, the largest oil producer in OPEC, is leading the way by lowering its oil production from 9.7 mbpd to 8.2 mbpd. However, Saudi Arabia does not have the massive financial and political pressures that Iran, Venezuela and non-OPEC member Russia have to contend with. All three of these nations need the barrel price of oil to be well north of $50 in order to sustain state budgets planned when oil prices were climbing.  After oil’s dramatic collapse, these countries are operating in the red and will be greatly tempted to ignore OPEC-established quotas in order to generate desperately-needed cash. It is possible that a sustained drop in oil prices could threaten the stability of the Venezuelan, Iranian, and Russian governments.

According to CNBC, the previous two OPEC production cuts have only met with an estimated 50% compliance. Expect that ratio to continue to fall if oil prices continue to slide and budget shortfalls intensify. So, in essence, although OPEC member countries are all incentivized to pledge production cuts in the hopes of generating a turn-around in prices, each member country has its own circumstances and many of the poorer nations are simply not going to sit on their hands waiting for oil to rebound. OPEC’s chronic failure to enforce its production quotas makes them of dubious value.

One part of the supply chain that we can track fairly accurately are domestic oil companies, many of which are reigning in capital expenditures greatly. The rapid decline in oil prices has made many U.S. oil and natural gas producers scale back on projects, especially the largest and most expensive ventures. Combine collapsing oil prices with difficult credit markets, and there is very little incentive for producers to bring new reserves to market at the present time. Nearly every company has found that certain projects that looked profitable six months ago simply do not make financial sense with oil now between $40-$50 per barrel. The latest round of cut-backs comes from SandRidge Energy (SD) and Equitable Resources (EQT), which are cutting CapEx spending by 50% and 40% respectively. Hess Corp. (HES) has indicated that CapEx will fall by nearly 40% in the coming year. In addition, Devon Energy (DVN) is holding off on setting a budget for 2009 until it officially closes the books on 2008, not a bad move considering recent volatility. 

While it is unclear just how much the supply will contract, it is clear that OPEC would like it to contract as quickly as possible. Global demand has been extremely weak in recent months as a world-wide recession has taken hold. Modern economies run on oil and when economic activity begins to grow again, watch out for a spike in oil prices, as supply will be likely be tight. This will only exacerbate the roller coaster ride in oil prices that we have seen over the past few years.

One word of note, readers of our blog will recall a post from October 16^th (Oil Stocks Are Cheap, But Will It Last?) describing the status of energy stocks as crude prices continued to drop. At the time oil had dropped exactly 50% from the high of $147 just a few months before, and I attempted to speculate as to where the floor in oil prices would be. I made the case that supply would be constrained by a further drop in prices from $74 as expensive production projects would be placed on hold, and that a drop substantially below $60 per barrel is not sustainable.

Well, let me say, that while a price this low may not be sustainable, I did not anticipate the steepness of the drop we have seen. However, my over-arching theory (as an equity analyst, not an energy analyst) was that oil stocks were due to rebound. And rebound they have, of the four stocks highlighted in that piece, only Transocean (RIG) is lower, dropping losing 18% since the post. RIG supplies deep-water drilling equipment and is especially susceptible to the declining price of crude. The big winner has been oil and natural gas producer Petrohawk (HK) which in two months time has gained 72%. Likewise the two major producers Exxon (XOM) and Chevron (CVX) have both gained more than 30% in that time.

So, the fundamental question is when will economic growth recover? According to the NBER, the current recession began a year ago, and it is already the 4^th longest recession in more than 80 years. We have included a helpful chart from the Wall Street Journal for reference.  We firmly believe that this recession is not going to be another Great Depression, as some pundits and politicians would have you believe. The Fed and other central banks around the world have pledge to take all available actions to preclude this type of economic catastrophe.  Yesterday, the Federal Reserve cuts its Fed Funds Target Rate to an historic low, .25%.   While it is anyone’s guess as to how deep this recession will ultimately be, it is likely that the worst is behind us and economic activity could very well begin to grow within the next few quarters.

The price of crude oil dropped again today to rest at a 13-month low of $74, and this represents a 50% fall from the peak price of just under $148 only three months ago. The declining price has been mostly attributed to slumping demand from a stumbling global marketplace. Let’s think back to 3 months ago and you will surely remember that the price of oil and more specifically the price at the pump was the number one topic of conversation. The reason being that as everyone now realizes, oil is the lifeblood of our economy and when it gets expensive the effects are felt by everyone. Granted a lot has happened in the last three months and financial markets are extremely volatile, but often times volatility can create opportunity.

Many investors surely noticed that the energy and basic materials sectors were down more than 14% Wednesday, and the question that must be asked is “what is the true price of oil?”. That is a tremendously complex question with factors both economic and geopolitical, but it’s in our DNA at Ockham to try to break it down to what is important and actionable. Remember when crude first crossed over $100 per barrel, we wrote (Relief at the Pump: Don’t Hold Your Breath) that it would be a while before consumers and the economy would get a break from expensive oil. Well, now eight months later after substantial price appreciation, the oil bubble has burst, which is a blessing because I shudder to think what this credit crisis mess would be with the added impact of record high oil, can you say stagflation?

We invite you to look at a great article from The Wall Street Journal (Crude Counting: How Much Should Oil Really Cost?), in it the author inserts some valuable metrics by which to judge the current oil futures market. From the WSJ, “For the last 40 years, oil has represented more or less 2.5% of global GDP, Deutsche Bank says. That should peg oil today at about $59 a barrel.” This is a reasonable assumption that oil would tend to revert to its historical average price. However, as the article later points out, oil that is cheap to produce has become more and more scarce, and that some oil these days costs as much as $80 per barrel to produce. Clearly, oil producers will not produce oil that will not make them money, and the laws of supply and demand will take over from there. If crude is being sold too cheaply on the international marketplace, supply will shrink and cause an increase in price. By this line of reasoning, the price of oil at $74 is already pretty cheap and a drop from here just means that the most expensive production projects will get put on hold.

So, the economic side of the equation seems to suggest that the global demand slowdown would need to be very significant in order to justify the price dropping too much further, what about the geopolitical side? We cannot foretell what will happen in the future that might create a supply shock—be it war, political unrest, or terrorist activities—so we will not get into that can of worms. However, we can formulate a calculated guess as to the behavior of OPEC in its upcoming meetings (Nov 18^th). Rest assured, OPEC will want to do all it can to drive up the price of oil to line their countries’ coffers with oil money. So, the odds of OPEC cutting production are quite good which suggests yet again, that cheap oil is a thing of the past. Interestingly, OPEC member countries will be in an interesting position similar to that classic game theory example of the prisoner’s dilemma. While all member countries have an interest in proclaiming to the world that the cartel members are collectively cutting production, it is to their advantage to cheat the other members by selling more than they were allotted. Keep that in mind, when OPEC’s likely announcement comes in November.

So, it seems reasonable to us that the price of oil has overcorrected after the commodity bubble’s burst. These most basic of factors discussed above, lead us to believe that for the  price of oil to slip too much further the global recession must be a major one to drop demand so drastically. If that indeed is the case, then no stock is safe and all bets are off. However, if that is not the case and the dip in global demand is shallow and brief that oil stocks will prove to be  a nice investment right now. There are undervalued stocks all over this market, but energy stocks could be quick to rebound when crude begins to rise. Some equities that interest us at present levels are Exxon (XOM), Chevron (CVX), Petrohawk (HK), and Transocean (RIG).  We have attached throughout this piece the ratings history charts for each of these securities, and each one of them falls into our Greatly Undervalued rating at present levels.  No one can know what the “true” or intrinsic price of oil is but you must take the data and try to identify a trend.

The sell-off in oil from its high of nearly $150 a barrel has been well publicized and many energy stocks that rode that wave up are now reeling as the price of oil plunges. Petroleo Brasileiro S.A. (PBR)—the state-controlled energy company of Brazil commonly referred to as Petrobras—is one such stock that reached levels that we view as overvalued (see ratings chart). However, after dropping more than 30% from its recent high in little more than 3 months, we have upgraded Petrobras to a Buy rating as of this week. Value investors should be moving in as the speculators sell. While the rapid drop in price may scare some investors, we believe the there is significant value in these shares for long term investors.

Petrobras could be sitting on one of the largest oil fields discovered in years in the Tupi-area fields. Estimates for the Tupi field reserves range from 5 billion to 8 billion barrels (85% light crude) and that would undoubtedly provide a healthy revenue stream for years to come. Interestingly, PBR has put a 12 to 18 month hold on drilling those fields while they conduct seismic and other various well tests. Perhaps they are also buying time to acquire rigs and raise the capital to operate them. The reserves in Tupi would require deep water rigs, which are not cheap to operate. The company plans to spend more than $200 billion to produce the crude. Petrobras has moved quickly to lease many of the deepest offshore rigs (source). With the price of oil in constant flux, there is no way to accurately predict what the earnings will be from this field, but we believe that it is reasonable to assume that oil will not drop markedly below $100 a barrel for any sustainable period of time and certainly could go far higher.

In addition to the much ballyhooed Tupi field, Petrobras has made other, albeit smaller discoveries. Earlier this month Petrobras began drilling in the Jubarte field in the Campos Basin with production potential of around 18,000 barrels per day. Also, they are eagerly exploring other potential off-shore sites hoping to find the next Tupi. PBR has partnered with some of the biggest American (XOM, HESS) and international (REP, RDS.A) energy companies to leverage their experience and expertise. In a short time, Brazil has quickly become a major player in oil and gas exploration.

Most of the blame for the sell-off in PBR shares is correctly attributed to the decline in crude oil prices. However, recently the stability of the company has been called into question as there are grumblings about a possible nationalization of PBR. The Brazilian government already holds a majority stake of PBR and has talked about increasing its stake in the company. There have been threats of oil workers strikes and other signs of unrest coming from Brazil. This is clearly a cause for concern for investors—and the company—but up to this point, PBR has affirmed that it will honor all existing contracts.

Returning to the stock’s valuation, as we mentioned before, it looks far more compelling than at any other period since we initiated coverage of PBR. The company is coming off of a tremendous, record-breaking second quarter. We particularly like the growth of revenues, which climbed more than 30% in the quarter over a year ago. Over the longer term, revenue has grown 220% over levels seen five years ago without even a drop coming from Tupi. At current price levels, PBR is selling within its normal price-to-sales and price-to-cash ranges, after trading far above their historically normal range for some time. We see this as an interesting growth stock to add to an international portfolio, especially for those that believe the price of oil will eventually be heading higher in the future.

Sky-rocketing oil prices have become a proverbial “hot-button” issue in this election year. The average cost of a barrel of oil was over $100 in the first quarter compared to just $58 in the first quarter of 2007. Consumers are frustrated by the prices at the pump, and businesses are feeling the pain too with increased energy costs. That is unless your business is energy, as this week oil companies such as BP (BP) and Shell (RDS.A) have reported huge 1^st quarter profits and earnings. However, Exxon Mobil (XOM) released earnings that account for the second best quarter in the company’s history but were below analyst estimates, and the stock of the world largest company is down nearly 4%. Exxon had the misfortune of trying to live up to its record breaking 4^th quarter 2007, but a drop in production and tougher conditions in the oil refining industry have made that an unrealistic goal.

The drastic rise in oil prices accounted for an increase in net income of 17%; net income per share was $2.03 and fell short of the $2.13 consensus estimate. The difference between the estimates and reality could be from an underestimate of how much drilling and production costs have increased. Exxon’s refining division was also a dreary spot as refiners squeezed their profit margins in a price battle. The Refining and Marketing divisions’ earnings were down nearly 40%. Furthermore, Exxon was not able to keep pace with past oil production numbers as they were only able to produce 90% of their production marks of 1Q last year. The seizure of some Exxon assets in the nationalization of Venezuela last year hurt, but production was also down in the U.S., Canada, and Africa. In an effort to ramp up production while the price is high, Exxon has increased its exploration budget 30%.

Exxon had enjoyed a very nice run prior to this report and the stock was up about 17% in the last year, compared to the Dow Industrials which are down more than 1 percent. Experts of the oil industry do not anticipate oil prices to fall substantially any time soon, and that should mean more good quarters ahead for the oil and gas behemoth. As a sign of confidence, management is increasing the dividend 14 %, which makes it 26 straight years of increases. Exxon is also continuing its planned share buy-backs as well. We believe that the stock is properly valued, and we have a rationally expected price range of $86-$101. The stock is selling with its historically normal ranges for price-to-sales and price-to-cash. Ockham Research would normally rate XOM a Hold given the current valuation, but given the overbought nature of the energy sector (IYE) our risk management metric has kicked in and downgraded each security within the sector. So, Exxon though fairly valued, is a Sell for the time being until the overbought condition clears.

As a quick note, oil companies will likely continue to have large profits and gasoline prices will stay high in the foreseeable future. As these topics will continue to grab headlines, there is a good chance that Congress will again take up the issue of a “windfall profits” tax. It does not take a deep understanding of how corporations work to know that the CEO’s and Board Members will not be the only one’s hurt by such a tax. It will be the owners of the company, many of which are average investors who happen to own XOM stock. In short, such a tax would not help the average citizen at the pump, but it would hurt the stock and its owners and is something that investors should be wary of.