Oil Price Spike May Not Justify Buying Big Oil Stocks

Includes: BP, COP, CVX, RDS.A, TOT, XOM
by: Bachar Samawi

Once again, oil prices are racing higher. The West Texas Intermediate (WTI) spot oil price closed at $109.49/barrel on 2/24/2012. Meanwhile, WTI April futures closed at $109.77/barrel while Brent futures closed at $125.47/barrel. Since the end of 2011, the WTI spot is up 11.1% from $98.83/barrel.

Meanwhile, "Big Oil" companies, also known as the "Supermajors", are also witnessing an appreciation in their share prices. The Supermajors are the largest six publicly traded oil companies, which include Exxon Mobil Corporation (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A), Chevron Corporation (NYSE:CVX), British Petroleum (NYSE:BP), Total (NYSE:TOT), and Conoco Phillips (NYSE:COP).

Big Oil Companies Market Capitalization
(as of 12/24/2012)
Company Market Capitalization
Exxon Mobil Corporation $413 billion
Royal Dutch Shell $229 billion
Chevron Corporation $217 billion
British Petroleum $149 billion
Total $127 billion
Conoco Phillips $101 billion

On a combined basis, the Supermajors have total market capitalization of about $1.24 trillion. Given such massive scale, they have become an integral part of many portfolios. Year-to-date, their share prices have appreciated anywhere from 3.3% for Chevron to 11.1% for BP:

Big Oil Companies Stock Price Change
Stock Price as of 12/30/2011* Stock Price as of 2/24/2012* Stock Price Change since 12/30/2011
Exxon Mobil Corporation $84.3 $87.34 +3.6%
Royal Dutch Shell $72.25 $73.54 +1.8%
Chevron Corporation $105.59 $109.08 +3.3%
British Petroleum $42.3 $46.99 +11.1%
Total $51.11 $56.46 +10.5%
Conoco Phillips $72.22 $75.95 +5.2%
*Split & Dividend adjusted price - source: Yahoo Finance

More strikingly, since the end of 2010, they have appreciated anywhere from 12.4% for Total to 24.3% for Chevron:

Big Oil Companies Stock Price Change
Stock Price as of 12/31/2010* Stock Price as of 2/24/2012* Stock Price Change since 12/31/2010
Exxon Mobil Corporation $71.04 $87.34 +22.9%
Royal Dutch Shell $62.95 $73.54 +16.8%
Chevron Corporation $87.79 $109.08 +24.3%
British Petroleum $42.09 $46.99 +11.6%
Total $50.25 $56.46 +12.4%
Conoco Phillips $65.07 $75.95 +16.7%
*Split & Dividend adjusted price - source: Yahoo Finance

In 2011, the annual WTI spot price averaged $94.88/barrel, which was 19.4% higher than the 2010 average of $79.48/barrel. Hence, it is not surprising that the Supermajors performed as well as they did. As a matter of a fact, Exxon Mobil's $41.1 billion in profits for 2011 were 35% higher than 2010, primarily due to crude oil price appreciation.

Although there are several factors that affect Supermajors' profitability and stock prices, such as costs, upstream vs. downstream concentration, environmental disasters, exploration discoveries, depletion of reserves, and economic growth, there is no question that a substantial increase or decrease in crude oil prices will play a major factor. Given recent gains in crude oil prices, and the forecast by many analysts for continued appreciation in the price of crude, could the Supermajors' stocks rally substantially more?

The main catalyst behind the recent surge in oil prices has been recent tension relating to the European expected embargo on Iran. In addition, there has been increased talk of a possible strike against Iran's nuclear facilities. Meanwhile, Iran has threatened to close the Straight of Hormuz, where the majority of oil shipments go through, while it has unilaterally announced a halt of its exports to some European nations.

Despite the size of the Supermajors, on a combined basis, they actually control less than 6% of the world's oil & gas reserves. According to the Oil & Gas Journal, as of 2010, the National Iranian Oil Company controls the largest reserves, equivalent to about 16.7% of the total reserves controlled by the top 50 companies. The top five companies control over 62.3% of the total reserves controlled by the top 50 companies: National Iranian Oil Company (16.7%), Saudi Arabian Oil Company (16.3%), Petroleos de Venezuela (12.8%), Qatar General Petroleum Corporation (9.4%), and Iraq National Oil Company (7.2%).

The U.S. currently is not on friendly terms with either Iran nor Venezuela, whose national oil companies control almost 30% of oil & gas reserves controlled by the largest 50 companies. In the case of Iran, geopolitical tension has contributed to the current spike in oil prices. However, as the U.S. has recently increased its domestic oil & gas production and has lowered its dependence on imported oil (although it is still highly dependent), it seems the risk may start building in the opposite direction; it is possible that the perception of a drop in such tension, or the continued decrease in the dependence by the U.S. on imported oil, could cause oil prices to drop substantially from these levels.

Another possible offsetting factor that has not been fully reflected is the recent drop in natural gas prices in the U.S. While crude oil prices have been spiking higher lately, natural gas prices in the U.S. reached a 10-year low last month of $2.23 for the front contract. Such divergence is rare, although, given near term logistical constraints in the transportation and liquefying of natural gas, it is not surprising. However, from an intermediate and long term perspective, such extreme price divergence should cause the adoption of higher dependency on natural gas, and possibly less dependency on crude oil. Technological advances and horizontal shale drilling have been the primary catalyst behind increased gas production.

An article published in 1998 by Scientific American, "The End of Cheap Oil", made a very compelling case as to why oil prices would spike sometime in the decade following the article, and would remain expensive. Indeed, the article's prediction came to fruition, and primarily for the same factors listed in the article which included geopolitical tensions, increased demand, dwindling new oil discoveries, diminishing returns on new technologies, realization of the M. King Hubbert curve theory, questionable statistical estimates of existing reserves, and more.

Ever since we first read the article, we have been a believer in its conclusions. However, something has changed recently. There have been some major technological advances that are actually yielding increasing returns, as opposed to diminishing returns. Cost effective advances in horizontal drilling and hydraulic fracturing in shale and certain geological formations are expected to boost oil production in the U.S. at least for the next 5 to 10 years.

In conclusion, we believe that the risk of de-emphasis of geopolitical tensions, cheap natural gas prices, slowing European economies and recent technological advances in horizontal drilling and hydraulic fracturing could possibly cause any additional upside move in oil prices to be limited. As a matter of a fact, we believe that in the short and intermediate term, such factors could possibly lead to a noticeable drop in oil prices. As a result, we believe this may be the right time to book profits on the stocks of Big Oil companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.