Oil And Gas Stock Review, Part I: Correlation And Review Of Large Foreign Developed Stocks

Includes: BP, RDS.A, RDS.B, TOT
by: Richard G. Pearce


Oil and gas stocks have long been a staple of value investors and dividend growth investors alike. A dividend growth investor should strongly consider having some exposure to the sector, as the large oil and gas companies have considerable stability as well as economical and political clout, such that many are able to weather almost any storm and quickly make up for diminished earnings and cash flow, even while growing their dividends.

Correlation and Fit

Here is a six month correlation chart for some of the various U.S. sectors, including energy.

GDX 1.00 XRT
IYR 0.10 1.00
IYZ 0.12 0.68 1.00
XLE 0.39 0.66 0.54 1.00
XLF 0.19 0.72 0.67 0.81 1.00
XLI 0.22 0.70 0.63 0.86 0.87 1.00
XLK 0.21 0.60 0.64 0.73 0.79 0.79 1.00
XLP -0.06 0.62 0.61 0.57 0.68 0.65 0.61 1.00
XLU 0.02 0.77 0.68 0.56 0.66 0.65 0.54 0.68 1.00
XLV -0.02 0.63 0.62 0.61 0.73 0.71 0.64 0.81 0.63 1.00
XRT 0.11 0.62 0.58 0.71 0.75 0.79 0.62 0.59 0.62 0.65 1.00

I also checked XLE against the above sector ETFs over a three year span, and the differences were not significant. This correlation chart tells me that there is some benefit, from a diversity standpoint, to having exposure to U.S. energy stocks, but the correlation is not so low as to make that exposure necessary. In other words, there is no need to have exposure to U.S. energy stocks, but it provides some benefit. Here is a three year correlation chart between the US energy index, a foreign energy index and some other major indices.

XLE 1.00
IPW 0.48 1.00
VTI 0.85 0.10 1.00
GWL 0.68 0.65 0.55 1.00
BND 0.01 -0.59 0.29 -0.51 1.00

Interestingly, foreign oil and gas stocks, as a whole, provide a significant amount of diversification from U.S. stock holdings, as they are only minimally correlated. If you are currently overweight in U.S. stocks, then there is an added diversification benefit to purchasing a foreign oil and gas stock, or at least the index. For those of you who are not very comfortable with correlation and its relationship with diversification, here is an article on the topic.

This article will look into three of the largest oil and gas companies in foreign developed economies. I will then look into emerging market opportunities in Part II before finishing with U.S. stocks in Part III.

Foreign Developed Economy Oil and Gas Stocks

British Petroleum (BP)

British Petroleum still has a fair amount going against it. There is still a significant amount of liability from the Deepwater Horizon disaster as well as significant risk related to its dealings in Russia. Management has also set some lofty goals, including the goal of generating cash flow of $30 billion in 2014 if oil is trading at $100 per barrel. To me, the exposure to Russian oil via Rosneft carries so much long-term risk (including but not limited to Russian government intervention, reduced dividend payouts, capital calls) that it validates a lower P/E and other fundamental ratios relative to its competition than it would otherwise have.

On the other hand, BP has a significant amount of access to oil and gas in the Gulf of Mexico, Russia and beyond, which should provide ample growth prospects. It also has largely completed its asset divestment program and paid the lion's share of its expected liability relative to Deepwater Horizon, so the worst is hopefully behind it. When I factor my discounted cash flow analysis, discounted dividend analysis and fundamental valuation analysis, I come to a fair value of $50-55, which implies that the stock is currently undervalued by approximately 20-30%. This price is within my margin of safety, so I consider it a buy.

Note that BP is paying a dividend of 2.16 per share per year, which, at $41.65 per share, is right at a 5% yield. As BP's revenues, earnings and operating cash flow approach 2008-2009 levels, it is possible, if not expected, that the dividends will return to the levels during that time as well, which were 3.30 and 3.36 per share per Morningstar. If you buy BP now and reinvest the dividends, then when BP's dividend reaches that prior peak, your yield on cost will be 8%.

Total S.A. (TOT)

Total S.A. does not have the same major headwinds as BP, but it also does not appear to have the same growth prospects. Specifically, TOT is struggling to efficiently replace its oil reserves, and as a result, it is having to take more risk and expense in order to grow its production. This risk and expense comes in the form of increased natural gas exposure, oil sands, deep offshore drilling and even its purchase of SunPower. TOT's return on equity is now in the 10-15% range compared to having been in the 29-35% range from 2004 through 2007. TOT has also cut its dividend at least three times in the past 5 years. When I factor my discounted cash flow analysis, discounted dividend analysis and fundamental valuation analysis, giving the greatest weight to fundamental analysis in this case, I come to a fair value of $50-55, but without much confidence. I would look for a price closer to $40 before I would consider purchasing.

Royal Dutch Shell (RDS.A, RDS.B)

Shell is another company worth considering as a dividend growth stock. As with BP and TOT, RDS has had some hits and misses. Some of the misses involve the Alaska rig incident and Shell's large bet on U.S. shale gas. Some of the hits are its innovations in gas-to-liquids technology and its more successful long-term projects in Qatar and Canada. Shell is generating approximately $45 billion per year in operating cash flow, so it can afford its significant, capital-intensive projects while maintaining a dividend payout ratio in the low 40s.

Shell recently raised its dividend to 0.90 per quarter from 0.86, for a 4.4% increase and a yield of 5.4% based on the current price of $65.69. This 4.4% increase in the dividend is actually high compared to the past four years, when annual dividends increased a total of 0.30 per share over a four year span, per Morningstar, for an average closer to 2-3%. Nonetheless, Shell managed to at least maintain, if not increase, its dividend every year since 2006, and it has ample cash flow and growth prospects to fund dividend growth well into the future.

My discounted cash flow analysis, discounted dividend analysis and fundamental valuation analysis result in a fair value in the $67-72 range. As a result, I do not think that it is a buy right now, but it is worth watching in case the stock price gets much below $60.

As always, please consult your advisor and/or perform your own due diligence before investing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.