Value investing in oil and gas shares

omanoil

Success in energy investing requires a nuanced and sophisticated grasp of positioning, sentiment and sector rotation.

The surge in US shale oil production, the Washington-Tehran nuclear/sanctions deal in Geneva and Saudi Arabia’s failure to reduce the 30 million OPEC output level in Vienna are all major macro bearish factors for crude oil prices. However, supply shock risk has risen in Iraq, Libya, Sudan and Nigeria while the soft December jobs number precludes aggressive Fed monetary tightening. This means Brent crude trades in a $105-115 range and West Texas in a $90-100 range. This means money making opportunities exist in Wall Street energy shares.

Energy was the sector Cinderella in 2013’s parabolic bull market on the S&P 500 index. Investors have low confidence in offshore drillers, E&P companies and European super majors even though I see smart money accumulating refiners, pipelines and oil services firms, as the stock charts of Valero, Baker Hughes and Halliburton demonstrate. Success in energy investing requires a nuanced, sophisticated grasp of positioning, sentiment and sector rotation as the smart money discounts the future in the financial kingdoms of black gold. Despite the stellar out performance of Exxon Mobil, Chevron and BP since late summer, energy investors are downbeat on the super major Seven Sister colossi, who are most vulnerable to a correction in the stock market indices they dominate. Pipeline companies are a low risk theme to benefit from the secular growth in US shale oil infrastructure.

After all, Texas produces more crude oil than Abu Dhabi or Kuwait, North Dakota produces more than Qatar and Oman. The IEA estimates that the US will replace Russia and Saudi Arabia as the world’s leading oil producer in the next decade. Kinder Morgan and Williams are the leading pipeline operators in the US.

Oil services firms benefit from the rise of new exploration opportunities (Iraq, Libya, offshore Mozambique, Russia). Mexico’s energy reform, the higher capex of GCC state owned oil and gas majors, land drilling in North America and a rising offshore rig count. This leads me to the Fab Four of oil services, notably Schlumberger, Halliburton, Baker Hughes and Weatherford.

Halliburton shares have fallen 12 per cent from 5 per cent in the past two months due to a general sell off in oil services. However, Halliburton’s deep water revenues are growing at a 30 per cent rate, its operating margins will be boosted by managements “Frac of the Future” concept and an significant rise in shares buybacks growth could well be 25 per cent for the next two years and the valuation is now attractive at 12.6 times current earnings. Halliburton is also making a strategic commitment to boost its Middle East/Africa/Brazil/Mexico businesses, the reason it moved its head office from Houston to Dubai. My buy/sell range on Halliburton is 45 to 65.

Occidental Petroleum, the firm that wildcatted the great oil strikes in the North Sea, Alaska and Libya, is restructuring its global asset base to focus on its California and Texas shale oil and gas acreage. This means Occidental could well sell its chemical, midstream and Middle East businesses to finance significantly higher share buybacks and dividend growth. This means Wall Street will rerate the valuation rerating on its shares, as pure play domestic US firms command a higher valuation than international diversified majors. Occidental is the leading producer in Texas’s Permian Basin. My buy/sell range on Oxy is 84-120.

High cost, legacy/politicised businesses (e.g. total unionised refineries and marketing networks in France), mediocre reserves/production growth and falling upstream profit margins make me negative on most European integrated oil companies. ENI is exposed to political risk in Libya/Algeria and Repsol is exposed to Argentina’s erratic, misgoverned state. By default, BG Group has been the winner in the sector though its London listed shares seem overvalued after its 20 per cent run. BP is still exposed to Deepwater Horizon litigation risk. In energy investing, I prefer the better relative growth potential in US oil services, refining and shale oil production.

Royal Dutch Shell’s incoming CEO stunned Wall Street with a profit warning two weeks into the job. Shell’s 48 per cent decline in earnings is due to poor refining spreads, cost inflation in exploration and a fall in crude oil/LNG output. A profit warning is highly unusual for a global integrated super major and Shell’s disappointing earnings show that it is vulnerable to political risk in its high tax, low margin, capital intensive projects in the developing world. Shell is underperforming in Nigeria, its Alaska drilling program, European gasoline refining and its global gas to liquid projects. Shell could well be forced to cut its dividend.

The US stock market is overvalued at 17 time S&P 500 earnings. A 20 per cent correction in Wall Street is possible if corporate earnings disappoint or China’s credit crisis escalates into a “Lehman” moment. The first major correction since September 2011 could be an ideal opportunity to buy energy shares on Wall Street.


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