On January 28, I argued that the U.S. economy is still in the early recovery stage of the business cycle, and that you should overweight your portfolio toward the stocks that do best at this point in the cycle: “Sectors that do best are usually industrials, near the beginning of the stage; basic materials; and, near the end, energy.”
The next stage for the U.S. economy is late recovery. “Sectors that have done well in this stage include energy and, near the end of the stage, consumer staples and services.” (For more on investing for the economic cycle see my post http://jubakpicks.com/2011/01/28/where-the-heck-are-we-in-the-economic-cycle-anyway-the-answer-is-important-in-deciding-what-sectors-to-overweight/ )
See any sector that those two stages have in common? So why not overweight energy right now? several readers asked. That way your portfolio can catch the sector’s outperformance at the end of the early recovery stage and the sector’s outperformance in the first part of the late recovery stage.
That’s an excellent idea. Just be careful what energy stock you pick. The sector is a little tricky to navigate right now. I’d favor being very selective on oil stocks—most of the international majors aren’t all that attractive currently. I’d favor oil equipment and service companies right now and small oil producers that are growing production and that look like acquisition candidates over the oil majors.
And I’m going to end this post with five picks of exactly those sorts.
What’s the matter with buying big oil now? After all the sector called ‘integrated oil and gas” has soundly beaten the Standard & Poor’s 500 over the last six months—gaining 23.91% for the six months that ended with January 31 to the S&P’s 17.93%–and in the three months that ended on January 31—gaining 12.82% to 9.3%.
But big oil—and I do mean big since ExxonMobil (XOM) has a market capitalization of $416 billion these days and Royal Dutch Shell (RDS) comes in at $217 billion—has recently shown signs of struggle. BP (BP), for example, closed at $49.25 on January 14 but closed at just $47.30 on February 16. Royal Dutch was at $73.35 on February 1 and $69.75 on February 16. Chevron (CVX) was at $97.74 on February 7 and $96.66 on February 16. ExxonMobil closed at $83.91 on February 1 and at $83.69 on February 16.
The problem that’s started to worry investors? Reserve replacement. And ExxonMobil’s end of year report is a good place to start in understanding the problem.
In 2010 ExxonMobil said it increased its reserve base by 2.5 billion barrels to 24.8 billion oil equivalent barrels. The increase enabled ExxonMobil to replace 209% of the oil it produced. In other words, even after all the oil it produced in 2010, the company ended the year with more oil than it had started with.
The problem with ExxonMobil’s reserve replacement report is that the 209% figure depends on the company’s big acquisition of XTO Energy. The purchase of XTO’s 2.8 billion barrels of reserves accounted for about 80% of the reserves that ExxonMobil added in 2010. Without the XTO purchase ExxonMobil’s reserve replacement ratio would have been just 45%, Barclays Capital calculates.
This isn’t a problem just for ExxonMobil and it isn’t a problem that’s about to go away quickly. The national oil companies of countries such as Saudi Arabia, Mexico, Iran, Brazil, and Russia produced 52% of the world’s oil in 2007, according to the U.S. Energy Information Administration, but they controlled a whopping 88% of the world’s proven oil reserves. To replace the oil that the international majors are producing, international oil companies have had to look harder to find oil and spend more to produce it. Chevron’s 2011 capital budget is an example of just how expensive this effort can be: For the coming year Chevron will spend $22.6 billion on exploration and production. That’s a big increase from the company’s already substantial $17.3 billion 2010 budget for exploration and production.
It takes time to turn capital spending into oil. Chevron has one of the industry’s best pipelines of new projects but the company added just 240 million barrels of oil equivalent reserves in 2010. That produced a replacement ratio of just 24%. (And the delay in the payoff for that investment is one of the reasons that the company’s stock sells for 10.2 times trailing 12-month earnings while shares of ExxonMobil sell for a trailing price-to-earnings ratio of 13.4%.)
The alternative strategy, one that ExxonMobil’s buy of XTO Energy exemplifies, is to acquire your way to new reserves. Not that this strategy comes cheap. It cost ExxonMobil $41 billon in stock to acquire XTO Energy in 2010.
Think about the investing logic of this situation for a moment. Where does it tell you to put your money?
If the oil companies that are following the Chevron strategy of spending on exploration are adding big bucks to their capital spending budgets, you’d want to invest in the companies that they’re spending that money with.
If the oil companies that are following the ExxonMobil strategy of spending to acquire reserves are willing to pay big bucks for smaller companies with promising reserves or exploration prospects, you’d want to invest in the companies they might acquire.
In the first group I’d look to own companies such as global oil service and exploration leader Schlumberger (SLB) and Weatherford International (WFT). My third pick would be FMC Technologies (FTI), a producer of deep-sea production and processing equipment. The company reminds me of the well-support group at John Wood Group that General Electric (GE) just bought at 17 times EBITDA (earnings before interest, taxes, depreciation, and amortization.) According to Bloomberg, over the last two years the average multiple in the 21 deals in the oil service and equipment sector was closer to seven. Either GE overpaid or the price of an acquisition in this sector has skyrocketed. In my opinion some of both, but the GE deal certainly suggests that this is a good time to own companies in the sector that might be acquired.
In the second group, I’d look to plays that are in the mode of XTO Energy. XTO not only had a lot of reserves but they also sat in the safe and friendly United States.
But I wouldn’t just play a guessing game and hope that I hit on the next buyout stock. I’d make sure that I was looking at companies that can themselves grow production aggressively in the next few years so that even if they aren’t bought, you’ll profit from that organic growth story. One of my top two is Oasis Petroleum, which has 39.8 million barrels of proven reserves and lots and lots of undeveloped acres under lease in the very promising Bakken oil shale formation. Proved reserves popped from just 13.3 million barrels at the end of 2009. I think they’ll continue to increase extremely rapidly.
My other producer pick is EOG (EOG). Think of this as a bigger Oasis with more exposure to natural gas. But the company has sizeable unconventional oil reserves and has been able to ride out the natural gas plunge by shifting production toward oil (67% of production by the end of 2011, the company projects) from natural gas (77% of production in 2007).
That’s five energy stocks for the end of the early recovery cycle and the beginning of the late recovery stage. Now if only the economy will cooperate and not slow down instead of accelerating.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Oasis Petroleum, Schlumberger, and Weatherford International as of the end of December. (I will have the January portfolio holdings posted this week.) For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/