Hedging the Oil Sector

Determining the fair value of an asset is both art and science. While traditional metrics such as Price/Earnings (PE) and dividend discount models offer the appearance of precise mathematical answers, these methods are widely used and do not always provide investors an edge. Over the years, I have used non-traditional metrics as a way to determine fair value targets and identify trading opportunities.

One example featured in EPIC Insights, my weekly investment newsletter, would be the method I use to value energy stocks. Having seen large increases in the price of oil and gas, integrated oil companies trade at low P/E multiples with high return on equity (ROE) and sizable dividend yields. If you used a P/E or dividend discount model, the price targets would be so high that an investor would think they should put all of their money into this industry. The lack of diversification and recent stock performance highlights the negatives of this action.

Since traditional metrics are not useful, how does one trade this sector? An alternative metric I have used is to examine the reserves each company reports, the current price of energy and then determine a fair value estimate.

With any alternative method, we must ask if the process intuitively makes sense and why it would be a valid measure. After all, investors valuing internet companies based on eyeballs during the dot-com bubble soon realized that alternative measures are full of risks. With energy companies, their business is to drill, refine and sell energy. Their reserves offer a view of future production and future earnings.

In addition, a leveraged buyout (LBO) view helps as well. The futures markets are deep and liquid. If an energy company is sitting on reserves, their management should be capable of determining when the oil and gas will come out of the ground and be ready to refine.

If you know when the energy can be delivered, you are capable of using the futures market to sell your production at prevailing prices at various dates in the future. The cash received from the futures market could then be used to take a company private. After all, if the stock market values your energy reserves at a discount to the future market’s view of energy prices, sell your energy at the higher price, buy back your stock in a leveraged buyout, drill the needed oil to satisfy your delivery obligation and retain the excess profit.

I have been using this metric with conservative assumptions for many years to determine if I thought energy companies where inexpensive or not. Over the years, this has served me well as I consistently purchased the shares at a 50-70% discount to fair value. Looking at the market now, something has changed.

Currently, the cost of Conoco Phillips (COP) is equal to my reserve value estimate. Given that shares purchased in January fetched an 18% discount and shares purchased in 2007 offered a 53% discount, why has the market’s perception changed? I can think of three reasons.

The first would be the market is bullish on energy prices and COP is priced in anticipation of an increase in oil and gas prices. For many reasons, I view a sustained rise in energy prices as unlikely and dismiss this explanation. The second reason is that the market has realized valuing energy companies based on reserve value is proper and the current price is correct. While possible, markets rarely change so quickly so I find this explanation to be unlikely. The third, most plausible explanation, is that the stock prices have not reacted to the drop in commodity prices and the stock prices are about to decline.

With the belief that the price of energy stocks will drop, shoring the large oil companies (i.e. – COP, XOM) is an excellent trade. To hedge the possibility of an increase in oil prices, consider a long position in the US Oil Fund (USO). By shorting XOM and COP while being long of oil, you profit from a return to the normal relationship between commodity prices and stock prices regardless of the direction of the underlying commodity.

Comments

[Dana Veitch:]

This is a brilliant article about the complex task of reaching a value of oil and gas companies with great reserves in the ground. I remember our M&A petroleum engineer at ARCO, officed next to me, years ago pulling his hair our, changing his evaluations daily of acquisition candidates' reserves. Buying oil and gas reserves now is a great, long term play. Where do you think your current investment value will be in 5 years? Where do you think the price of oil will be in 5 years? It's simple.

2008 Dec 23 10:22 AM