Slowing global growth means a protracted bear market in crude oil.
Saudi Arabia’s decision to pump and export the highest crude volume since the Shah of Iran lost his Peacock Throne three decades ago (Saudi production hit 10 MBD in June), coupled with the return of Iraq and Libya to the oil market, led to an increase in the supply of black gold even as its demand curve moved lower due to recession in Europe and a possible hard landing in India and China. It was no surprise that Brent crude was gutted from $126 in early March to below $90 in late June.
However, the EU embargo against Iran moves at least one million barrels daily from the international oil markets and has triggered a nationalist backlash in the Majlis, the military high command and the Revolutionary Guards, whose naval units have fired missiles and conducted military exercises in the Gulf of Hormuz. There was a Norwegian oil workers stike. This is the first supply shock in the oil market since the Libyan rebels shut down Colonel Gaddafi’s refineries, pipelines, storage tanks and loading terminals in autumn 2011. As Brent rises above $100, oil shares are natural candidates for accumulation. Who? Why? Where?
I still believe slowing global growth means a protracted bear market in crude oil, possibly Brent $75-80. After all, the collapse in the Iran riyal, 25 per cent inflation and social unrest could force the Ayatollahs to compromise with the West on its uranium enrichment programme, removing the geopolitical risk premium in crude oil. This means it is still safer to buy low beta, high yield, low valuation, integrated supermajors, such as BP, Shell, Chevron and Total. Exxon Mobil’s gas exposure via its takeover of XTO. Energy and its chemicals business, reduce its correlation to crude oil prices. I am less keen on offshore drillers, LNG, cola shares and would avoid alternative energy shares like the plague (aint nothing green about First Solar!).
Oil services shares plummeted as Brent plunged $30 since March as the financial markets feared that the fall in oil prices would force exploration/production companies worldwide to slash capex budgets. This was all the more so since natural gas drilling in the Gulf of Mexico, Texas and Oklahoma is under pressure and oil service companies could well be victims of new downward EPS revisions. However, it is unlikely that the US rig count will drop much below 2000 in 2012 and state owned oil and gas colossi, from the GCC national champions (ADNOC, Qatar gas, Kuwait Petroleum, Saudi Aramco) to the emerging oil and gas operators in Libya/Iraq, China’s CNOOC and PetroChina, Brazil’s Petrobras and Russia’s Rosneft, Lukoil and Gazprom will actually increase their capex, as their sovereign status makes them immune to short term seizures in oil prices or credit markets.
However, as the global economy slows, a protracted period of lower oil prices could dampen high cost drilling projects in offshore West Africa, offshore Brazil, the Russian Arctic and the Alberta tar sands. This would be negative for oil services companies. Schlumberger is the world’s leading oil services firm and increased its footprint in deepwater after its acquisition of Smith International. It is the most global among the major US oil services firm. However, Schlumberger has a lower exposure to the North American natural gas/pressure pumping segment than Halliburton or even Baker Hughes.
Schlumberger is also the Texas (French?) oil service firm most leveraged to the capex budgets of the world’s leading state owned companies in the BRICS/major emerging markets. EPS could well be in the $4 range and I doubt if Schlumberger’s valuation multiples will fall below 15 unless oil prices crash again. This means the world’s leading oil & gas services firm, whose shares peaked at 95 in this crude cycle, has a value at 60-62.
Chinese slow down
Lower electricity and fuel demand is telltale evidence of a Chinese economic growth slowdown. The fall in Brent and the slowdown in China energy demand/GDP growth in a year of political transition (the Year of the Dragon, no less!) mean the shares the CNOOC, China’s leading offshore oil and gas exploration and production companies lost a third of their value in its New York ADR (symbol CEO) and its Hong Kong shares (883 HK). It now makes sense to nibble at CNOOC shares in New York and Hong Kong, since this Middle Kingdom Red Chip is among the world’s most lean, mean operating machines in Big Oil. This is a tribute to its low cost operating base in coastal and offshore China, the home base for almost 80 per cent of its offshore oil and gas platform. CNOOC reserves are now valued in the Brent $72-82 range and its dividend yield is a respectable 3 per cent, making the shares compelling at eight times earnings (the five year average multiple is 12X).
CNOOC also trades at a mere four times its cash flow, can increase production by 8-10 per cent and minimal exposure to natural gas (one fifth of reserves and production). However, rather than buy the shares of CNOOC’s New York ADR at $200, I would prefer to sell put options at the $180 strike whenever volatility in global markets spikes higher.
Conoco Philips, is in the midst of a strategic restructuring. Conoco has sold its downstream assets and transformed itself into a pure play oil and gas E&P firm, though I concede production growth is a mediocre 3-4 per cent. However, asset sales, oil royalty trusts, share buybacks, rise in EPS growth will mean that the shares of this undervalued Big Oil could rise on the NYSE, possibly to as high as $78 in twelve months. The ultimate dividend yield oil share! France’s Total, with 6 per cent.