The case for oil stocks

One of the more frustrating investments in 2003 has been the energy sector. Despite being right about oil prices remaining higher for longer than the consensus, the stocks have done poorly in relative terms. The stocks currently trade at significant discounts to the market and are by and large out of favour.

My original thesis on the sector had been that oil prices will remain strong in 2003, surprising the consensus, with the occupation of Iraq not a catalyst to bring prices down to $ 20 a barrel ( as everyone was assuming at the beginning of 2003). I had also felt that the sector was a good hedge to alternative economic scenarios.

If the global economy were to recover strongly in the second half of 2003(eventually what happened), investors would be less worried about sustainability of oil prices as demand accelerated, and if the global economy were to weaken then the defensive nature of the sector would help.

However in reality the sector suffered in 2003 due to its perceived defensive characteristics, and refusal by investors to give any credit to the stocks for higher oil prices despite the clear acceleration in global growth. Traditionally oil stocks have tended to have a loose correlation with oil prices but in 2003 this dropped to basically zero.

Despite this being the fourth year in a row where oil prices have averaged above $ 25 per barrel, investors still seemed unwilling to value the stocks on anything other than some notional long-term equilibrium price of $ 18-20 per barrel. Investors were also disappointed by the continued inability of the oil majors to meet promised production targets.

Be that as it may, the fact is the sector has underperformed and one has to question whether one is missing something in still being positive.

One argument presented which is more structural in nature is to compare the sector to large capitalisation pharmaceuticals and note that both these sectors are being de-rated for their inability to grow by finding new drugs/oil. While it is true that most of the oil majors are finding it increasingly difficult to grow production, with frequent slippages in the targets presented to investors, the comparison makes no sense.

For pharmaceutical companies their entire lifeblood is new patent protected molecules. As their older products go off patent, prices drop 60-65 per cent and a whole slew of generics enter. If a large pharmaceutical company cannot discover and launch new products then its entire survival is in question.

Take the case of Schering Plough in the US where earnings will be down 90 per cent between 2002 and 2004 due to expiry of patents and the inability to launch new molecules to replace the patent protected drugs.

In the case of oil companies, if they are unable to find new oil reserves, the price of their existing output does not collapse, in fact it will rise. To the extent that most oil majors are finding it more difficult and expensive to find new reserves or grow production, the value of their existing reserves and production will increase and this is a critical difference.

If we take the extreme case of no new oil being found ever again, oil prices would rocket, very different from the collapse of drug prices if no new drugs were ever discovered. Also oil companies are much more levered in terms of profitability to oil prices as opposed to production volumes.

The other anomaly to me is the differential treatment accorded by investors to industrial commodity or mining stocks compared to the oils. Both these sectors had their peak in the inflationary late '70s when oil stocks accounted for almost 25 per cent of global profits and mining about 4.5 per cent.

Over the last 20 plus years as disinflation took hold, their shares of global profits consistently declined bottoming out at 5 per cent for the oils and 1 per cent for mining. Over the last couple of years both sectors are seeing their share of global profit starting to inch up.

Yet the performance of these sectors has been very different, investors are falling over themselves trying to buy mining/industrial commodity stocks while panning the oils. The oils now sell at a record discount to the commodity stocks on a forward P/E basis as well as on price/book metrics.

2004 has begun with a whole slew of upgrades on industrial commodities by Wall Street, broking houses are now talking about a supercycle for industrial commodities and how all investors must continue to increase their exposure to these stocks. They cite two structural factors supporting the commodity bull case.

The first is that the problems of the last 20 years have led to a much higher level of consolidation thus boosting pricing power(hopefully) of the companies in these sectors. The second structural factor is the growth in China and its industrial base. China as is well known now is a huge importer of industrial commodities and is on the margin, the main driver of growth.

Both of these so called structural factors apply to the oils as well. The oils are also quite consolidated with the three super majors and very few marginal players. While there are more national companies(country champions) in the oil business the presence of OPEC ensures some element of pricing power for the industry.

OPEC's power has fluctuated over the years but for the last four years it has clearly been effective. It is even thinking of raising its preferred price band of $ 22-28 per barrel to account for the fall in the value of the dollar, a sense of its growing confidence.

China has been an equally important factor for global oil demand accounting for 40-50 per cent of the growth in global oil demand in 2002 and 2003.

China in particular and Asia in general are inefficient users of oil and thus as this part of the world continues to grow faster than the global average, it will underpin oil demand. The demand side case for the oils and industrial commodities is very similar, faster growth in the developing world which is a more intensive user of raw materials be it oil or copper or aluminium.

The other structural similarity between oils and commodities is the lack of investment as companies in both the sectors have become more disciplined. In both areas, the ratio of capital spending to depreciation over the last five years has plunged to levels well below their long-term average.

The story sounds quite similar for the oils and industrial commodities does it not?. Yet investors refuse to value the oils using anything more than an assumed long- term equilibrium price of $18-20, while happily bidding up industrial commodity stocks on the basis of rising commodity prices. I do not seem to hear too much discussion or debate on the long-term equilibrium price of iron ore for example.

The oils are trading at a valuation discount to the commodity stocks, have higher yields and are unloved. On the other hand, everyone loves the commodity stocks, knows the structural bull case and these stocks have done very well.

To me the investment case for both is quite similar but they are treated very differently by investors. Does that make sense?