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Back in August of 2010, I wrote the Seeking Alpha article, Is Wall Street Undervaluing American Oil Companies?.

Let’s take look at the price performance of the top 3 U.S. oil companies since that article was published. The chart below summarizes the move.

COMPANY

SYMBOL

PRICE

8/1/2010

PRICE

1/31/2011

Change

Exxon Mobil

(NYSE:XOM)

$59.68

$80.68

+35%

Chevron

(NYSE:CVX)

$76.21

$94.93

+25%

Conoco Phillips

(NYSE:COP)

$55.22

$71.46

+29%

Not too shabby. These returns are even more impressive when you tack on a couple dividend payments. Obviously, the answer to the headline question was “yes” - Wall Street was certainly undervaluing these companies. The question now: Is there still value in these oil companies after such a large move? Well, let’s take a look. The following chart summarizes 2010 earnings, trailing P/E values and current dividend yields.

COMPANY

PRICE

EPS

(FY2010)

P/E*

DIV

YIELD

Exxon Mobil

$80.68

$6.22

12.97

$0.44

2.18%

Chevron

$94.93

$9.48

10.01

$0.72

3.03%

Conoco Phillips

$71.46

$7.61

9.39

$0.55

3.08%

* Trailing 12 month earnings (2010)

All three companies announced earnings over the past week. Considering the rise in the price of a barrel of oil year-over-year, it comes as no surprise earnings were much higher: up 53% at XOM, up 72% at CVX, and COP was up 54%. Of particular note:

  • Exxon Mobil announced significant production growth above and beyond XTO’s contribution.

  • Operational profits in the chemical segments were particularly impressive

  • Chevron’s reserve replacement was a big disappointment at 24%, an 8 yr low.

  • Conoco Phillips continues to execute well on its asset sales consistently beating estimates on received asset sale prices

But back to the question – is there still value in these companies after such a nice run the last 6 months? My regular readers know this is a rhetorical question - it is tantamount to asking is there value in a barrel of oil. I believe we live in an era when worldwide oil production will have much difficulty keeping up with worldwide oil demand. Increasingly, new discoveries are in deep water off-shore and will therefore be expensive to lift. Meantime, like rust, depletion rates on mature fields never sleep.

Add to this the increasing oil demand out of China, India, the Middle East, and the rest of the emerging world and you have a very strong fundamental supply/demand backdrop for oil. The fact that these companies (with the exception of XOM) pay a decent dividend, and their P/E’s are very conservative given their prospects, the answer is yes – these companies still represent good value at current prices. A look at their chart prices shows none of the three has revisited their price highs of 2008 even though their pencils and management are certainly much sharper after negotiating the recent financial turmoil.

Of course, there might be bigger bang for the buck in smaller American companies like Murphy Oil (NYSE:MUR), Marathon Oil (NYSE:MRO), Occidental Petroleum (NYSE:OXY), or Hess (NYSE:HES). But these companies have also made nice moves and in general pay lower dividends. However, there is a risk/reward factor in play with the smaller companies. They are generally more levered to oil prices than are the Big-3 integrated. That said, Murphy’s recent one day haircut reminded us that drilling dry holes a much bigger affect on a small company’s valuation.

Of these smaller companies, Marathon may be the best investment now. Their recent announcement to split into two companies (roughly upstream and downstream) should unleash value above and beyond the stock’s recent pop in valuation.

click to enlarge

Long term, all these oil companies continue to be valued as if Wall Street believes the U.S. is making significant headway in reducing oil consumption and foreign oil. Nothing could be further from the truth. There are three main risks when investing in the Big-3 oil companies:

  • America will adopt a strategic, long-term, comprehensive oil policy to reduce oil imports by adopting natural gas transportation

  • Electric cars will be deployed in such numbers so as to significantly reduce oil consumption

  • Oil production in Iraq will grow so fast as to swamp the world with new oil

  • Black swan events as a result of governmental or fiscal irresponsibility will cause more economic or geopolitical turmoil causing a big drop in oil consumption

Let me address these risks one at a time. With respect to an energy policy, there is no indication the Obama administration or current Congress is any different whatsoever from the previous 8 years of Bush administration. The U.S. simply does not have a comprehensive energy policy to reduce our 60% dependence on foreign oil. Our politicians apparently believe the best way to keep oil consumption down is to keep unemployment high.

Worse, the believe printing money out of thin air to pay for the $1 billion dollars leaving the country every day to pay for oil is a smashing idea. Since our “leaders” apparently need help, I offer here an energy policy plan that could very easily reduce foreign oil imports by 5,000,000 barrels a day within 5 years by adopting natural gas transportation. Better yet, the payback on investments in natural gas refueling stations and NGVs would be very fast and then pay dividends to all Americans for decades into the future. That said, from some of the comments I get on my articles, it is clear than many Americans would rather stay addicted to foreign oil and enrich countries like Iran, Venezuela, and Saudi Arabia.

While I certainly support electric vehicles and Project Better Place, it is a fallacy to believe electric cars alone will be able to significantly reduce foreign oil imports in the U.S. over the next 5-10 years. First, middle class Americans are struggling just to survive. How many Americans can afford a $40,000 EV that has limited range, limited recharging options, and an unknown battery reliability record? And where are the cars? The U.S. is a big country, with many mountainous regions as well as cold and hot environments. We have adopted a suburban sprawl requiring long distance commutes just to get to work. The EV will have much difficulty serving the needs of a majority of Americans from a cost and functionality aspect.

Oil production in Iraq could indeed come online in significant amounts. The oil is definitely there (and thus why the U.S. invaded in the first place – but that is the subject of a different article). However, the questions are:

  • Does the infrastructure exist to do so?

  • Will the increased production make an impact on the energy supply/demand equation (depletion rates, new oil field production, surging emerging market demand, etc).

Statements from major oil company CEOs involved in Iraqi oil production seem to indicate the infrastructure in Iraq is a problem. Then, of course, there is the security question. From what I can see, Iraqi oil production coming online in significant amounts to severely affect the price of a barrel of oil is not a risk I worry about. After all, would the oil companies producing oil in Iraq shoot themselves in the foot by over-producing? I think not.

We are reminded by Egypt that a “black swan” event continues to be the biggest risk to investing in these oil companies. But that same risk applies to any investment these days. The question is: where is the best place to be invested during these uncertain and government controlled times such that you can keep up with the devaluation of your currency and savings caused by the Federal Reserve and America’s refusal to adopt a logical energy policy? All my work tells me the best options are to invest in oil and precious metals. Good luck to you.

Disclosure: I am long COP, MRO.

Source: Is There Still Value in the Big 3 American Oil Companies?