The Dividend Investors' Guide: Part II - Integrated Oil 2013 Review

Includes: BP, CVX, OXY, XOM
by: Mark Bern, CFA

By Mark Bern, CPA CFA

In Part I of the original series I discussed the basics about my selection methodology in what constitutes a quality company from my perspective. It would be instructional for readers to review that article and the 10 rules I set out there to get the most out of this and other articles in the series. In Parts II through XXV of the series I provided my overview analysis of the most of the industries I follow and invest in personally.

In the review articles, I will provide a progress report on those companies previously included on my master list of investable dividend growth stocks, including additions and deletions to the list by industry. Since the review portion is generally in summary format I will attempt to cover more than one industry in each review article so we can get through them fairly quickly. However, I will go into more detail on additions and provide and thoughts I have regarding changes occurring in an industry where I think it may prove beneficial to readers. If my views do not change, updates will be brief.

In this article I will review the integrated oil industry with the four companies that made the list in the previous article. Things are changing in this industry due to advances in technologies for hydraulic fracturing (fracking) and horizontal drilling. The U.S. is leading the way in this relatively new method of extraction but even larger deposits may be found in formations underlying China and possibly Argentina. The future holds tremendous change and, most likely, many more forecast revisions for world supplies (something I have been saying would happen for a few years now).

Industry Update

Energy independence for the U.S., considered unrealistic just a few years ago, is something that could actually be achieved with better support from the federal government. The potential economic ramifications alone are enormous and portend a significant shift in favor of U.S. industrial growth and future jobs. While I agree totally that the end goal needs to include technological advances to help us conserve and use our resources wisely, including advances in renewable sources, I also believe that stifling oil and gas production on federal lands and offshore is an extremely poor policy. We don't need to use up all our carbon-based resources as fast as possible. But we do need to unlock portions of what we have periodically to provide our industries a home-field advantage in global competition. If we want to attract more factory jobs back to U.S. soil, we need to leverage what resources we can muster to create a lower cost incentive for companies to locate new plants and facilities nearer the source of plentiful energy resources. At some point I do believe that our political leaders will figure it out and allow the U.S. industrial companies to level the playing field. Okay, that's all I'm going to say on that issue.

Once the shift gets underway on a broader scale (to include more government controlled deposits) energy costs in the U.S. should stabilize at a level that will make operating many businesses closer to the end-consumer market (U.S. consumers) and avoid costly and lengthy transportation from Asia. Some industries stand to benefit more than others and I will get into that more as I update those industries in the near future. But I don't believe that the price of oil is likely to drop significantly from current levels as overall global demand is projected to continue to rise long-term. Also, I don't expect the savvy business leadership of the oil industry to cut its own throat by creating a supply glut. Discovery is one thing. Increasing production to meet demand is something else, altogether. With hundreds of billions of dollars at stake annually, the oil industry will maintain prices at profitable levels. From a geopolitical point of view, the biggest change I see on the horizon is that the companies operating in the U.S. will play a greater role in determining pricing, taking the "stick" away from OPEC. That, in my humble opinion, should mean much less volatility in oil prices as we approach energy independence.

The Energy Information Agency (EIA) of the U.S. Department of Energy has not changed its demand forecasts since the original article was published May 31, 2012. Demand will continue to rise gradually, hitting an average of 95 million barrels per day by 2016 and approximately 112 million barrels per day by 2035. Actual demand will probably vary on a year-to- year basis from the forecast due to periodic economic recessions and recoveries, but the trend should remain intact for the long term.

The world has more than a 1 billion cars and trucks on the roads (estimate from this article) and some analysts expect that total to surpass 2.5 billion by 2050. That may be a bit high, but it is not unreasonable to expect a significant increase with literally hundreds of millions of previously impoverished people in developing countries becoming consumers over the last decade and even more to come in the next few decades. Autos per capita ownership will not need to come remotely close to that enjoyed by citizens of the U.S. for the number of autos owned privately to double. After what has happened in the BRICS economies over the last two decades it becomes mind-boggling to think of future global transformations over the next 35 years or so. World population is projected to hit 9 billion from the current level of 7 billion. All of them will want electricity. Heck, a lot of people in the world still don't have electricity. But many of them want it. And governments and private utilities are expanding their efforts each year to connect more and more people to the grid. The next thing you know, they will all want to turn in their rocks for washing machines!

I did mention in the original industry article on integrated oil that significant progress in renewable energy is likely. But I want to reiterate that I don't believe that the progress will be enough to completely offset the new demand being created at the same time. Cars will be more efficient. Perhaps wind, solar, geothermal, hydro (natural water currents in rivers and offshore) will become more cost efficient and play an expanded role. Energy storage advances and improved grid management systems will also help. But I believe that the improvements will only slow the growing demand for fossil fuels for at least the next 15 years (and probably longer). Thus, the integrated petroleum industry stands to prosper for much of my lifetime. So, as much as has changed in the industry, the demand side prospects remain about the same.

The supply side is where things are getting interesting. Technology has not only allowed companies to find and extract smaller, hard to reach deposits in shale formations, but advances have also increases the amount of oil and gas that can be recovered from existing wells that were previously considered "dry." Not too many years ago, oil producers could expect to extract only about 35 percent of the known amount of fossil fuel from an underground formation (from this article about oil recover in Texas). Today, that percentage is increasing and, with additional advances, recovery rates will increase even more. So, if the recovery rate is eventually increases to 70 percent, the amount of technologically recoverable oil discovered throughout all of history doubles. I don't know if, when or how such level may be achieved. But, I have little doubt that the industry will continue to invest billions in ever-improving extraction technologies.

There is an interesting article at the Carnegie Endowment for International Peace by Deborah Gordon. It discusses and provides nice graphics to illustrate how technology has increased the world's oil reserves by a factor of 5 times since 2000 from 1.3 trillion barrels to 6.5 trillion barrels. It goes on to predict that further advances will increase the total to as much as 24 trillion barrels, including "unconventional oils" such as tight, bitumen, kerogen, gas to liquids, methane hydrates, and coal to liquids. That would provide approximately a 500 year supply. This is something to think about when considering "peak oil" predictions.

Will abundant supply give rise to much lower energy prices? I have my doubts. Remember that the goal of oil producing companies the world over, both private and government-owned, is to derive a profit. The key word in the previous sentence is "profit." If supply increases too quickly, prices will drop. Therefore, I expect industry leaders to continue to focus on finding and developing new resources and applying new technologies to older reserves in a managed fashion in order to continue to meet demand without creating oversupply conditions. Global companies will continue to buy and transport from foreign sources when the overall cost is less and reduce supply from sources that are more expensive, constantly attempting to manage supply levels to meet demand at the lowest possible cost while maintaining prices within a range that provides adequate margins. Energy independence may not translate into not buying oil from abroad, but rather into maintaining both a lower and upper bound on the range of prices. It is for this reason that when I mention stability of prices I do not mean flat prices. Instead, I refer to gradually upward trending prices with less volatility in the total range of prices.

Could prices fall significantly? Yes, it is possible for that to happen. But, I would not expect prices to remain depressed for an extended period of time. All that is likely to happen is that we will be presented with a great opportunity to buy more shares of the leading companies at bargain prices.

Chevron Update

Chevron (NYSE:CVX) may see a second straight decline in earnings per share (EPS) for the full fiscal year in 2013. Global demand remains sluggish and the average price for crude ended the first half lower than in 2012. But oil prices have rebounded due to continuing tensions in the Middle East helping to raise the average price for the remainder of the year. CVX production is being ramped up in newer fields but was offset in the first half by lower production from older, more depleted fields. I expect revenue and earnings for the full year to be only fractionally lower than in 2012.

The good news going forward is that CVX is moving decisively to expand in the natural gas liquids business where prices in Europe and Japan are still much higher than the costs to extract and transport it from Australia and Angola through LNG facilities either built or under construction. Also, the average price for natural gas has increased significantly in 2013 from 2012 which should provide some support for overall margins.

Refining margins decreased in 2013 compared to 2012, but I expect improvement in this area in 2014. Meanwhile, the company continues to aggressively buy back shares and offers a nice dividend, both of which are handsomely supported by more than ample cash flows.

The share price has advanced by more than 22 percent since the original article was published, from $97.63 to 119.65 (all current prices in this article are quoted as of the market close on October 16, 2013). Total return, including dividends, has been 27.4 percent or 19.3 percent annualized. This is more than the average total ROI that I had predicted of 14 percent and makes the issue a bit pricey at the time. The dividend has increased from $3.60 to $4.00 (11 percent) in the latest year, in line with expectations. I would prefer to not add CVX shares above $112. I remain very optimistic long-term regarding CVX and have a five-year price target of $175.

Exxon Mobil Update

Exxon Mobil (NYSE:XOM) remains an excellent long-term investment because of its broad diversification in assets both geographically and by type. The share price closed on Friday, October 18, 2013 at $87.55 compared to $79.79 per share on May 31, 2012. This represents a gain of $7.76 plus dividends of $2.97 per share for a total of $10.73, or 13.4 percent (9.4 percent annualized). This is below my expected total annualized ROI for XOM of 12 percent. The current dividend is $2.52, an increase of 10.5 percent year-over-year.

XOM is investing heavily in expanding production around the world, especially in Canada. If the company can keep project on schedule it expects to add about 800,000 barrels a day from these efforts by the end of 2015. That increase will be partially offset by lower production at older fields and also by asset sales. But I expect the net increase to make shares of this behemoth worth holding. XOM is fairly priced by my estimations at current levels. My five-year price target is $132 per share.

Occidental Petroleum Update

The current share price of Occidental Petroleum (NYSE:OXY) is at $98.29 compared to $80.29 in the original industry article. This, along with the dividends collected of $2.90, provides a gain of 26 percent, or 18.4 percent on an annualized basis. The company increased the dividend by 18.5 percent this year to $2.56 from $2.16.

The company has an excellent balance sheet with a healthy cash flow to support the dividend. OXY is likely to make additional acquisitions in the future that should keep both top and bottom lines growing nicely. The company is a technology leader in retrieving deposits from hard-to-reach reserves and mature fields. This is a big plus since both areas should provide huge potential in coming years.

The appreciation rate is well ahead of my projected 12 percent average annual ROI. Either I am too low or the stock has gotten ahead of itself again. This issue tends to be fairly volatile so waiting for a better price is advisable. I'd be tempted to add shares of OXY if it gets below $90 again. My five-year price target remains at $136 per share.

BP Update

BP (NYSE:BP) continues to provide the best dividend yield of the group at a current 5.0 percent, including the 12.5 percent increase over last year to $2.16 per share. The price has risen from $37.02 to $43.33 since the original industry article. Adding the appreciation and the dividend together provides a return of $8.95, or 24.2 percent, or 17.1 on an annualized basis. This is on the low side of my projected average 20 percent annual ROI, but not out of line since the stock was beaten down by numerous problems (Gulf oil leak and litigation and forced asset sale in Russia to name the big ones). The legal issues remain a concern as it appears that the original $20 billion that the company had set aside will likely need to be increased to cover claims arising from the spill. Thus, the stock continues to be underappreciated by investors.

Other issues have investors concerned as well. Production continues to fall, primarily due to asset sales, and average prices have been soft for much of the year. But this is another huge company with excellent staying power and better long-term prospects. I expect that the bottom in production levels will be hit within a year and then for volumes to begin to increase again, but gradually. The key to BP's future success is increasing its margins. Several ventures set to come on line soon are expected by the company to be more profitable than assets that have been divested, adding promise to future margin expansion.

I believe that BP continues to be worthy of consideration for long-term investors looking for good yield combined with above average appreciation potential. I continue to expect the stock to rebound nicely once the oil spill litigation is settled and behind the company. The company has adequate cash available from the TNK-BP buyout to cover continuing operations (including E&P), dividends and litigation. The stock remains slightly undervalued at current levels and a good buy on dips back down below $42. My five-year price target is $72.

This industry continues to be a good long-term holding and deserves a spot in most dividend growth portfolios. As always I welcome comments and will attempt to answer any questions.

Disclosure: I am long CVX, XOM. 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.