Back to Part 4
By Mark Bern, CPA CFA
This article will begin with my views, both short and long-term on the industry fundamentals and end with an assessment of some of my favorite companies in the industry. I will follow up with another article to deal with the remaining widely-held companies in the industry, including explanations of why each company did or did not meet my master list criteria.
Let's start with an overview of the industry prospects. I like to look out at least three to five years so I'll use the projections from the Energy Information Agency (eia.org) for 2016. That can be found at this link. Be patient as the link takes a while to load.
Global demand for oil was expected to weaken at least through the first half of 2012, and it has. Therefore, oil prices are softening and the prices of oil stocks are drifting lower. But, again, I believe that the real story in the longer view for this industry.
Current daily global demand for oil is 90 million barrels per day for 2012 and demand is projected to increase to 95 million barrels daily in 2016, respectively. If we look further out on that same chart we see that demand is projected to be 112 million barrels per day by 2035. This represents a 27 percent increase from current levels during a time when oil production is expected to peak. The obvious result is a continuing trend of higher oil prices.
Petroleum is not going to be replaced as a primary source of energy for at least a decade or two; and that is being optimistic in terms of expecting technology to replace black gold. In the short term, oil prices are under pressure due to slackening demand from China and Europe. I suspect that there will be some saber rattling in the Middle East before the price of oil drops below $75 a barrel, though, in order to provide support for the region's primary export and source of prosperity for those lucky enough to be in a position to benefit. The Middle East is still a very volatile region and Saudi Arabia still controls the world's excess capacity for crude. The price of oil depends on how low the Saudi's want to let it fall, in my opinion. I don't think the tolerable bottom for Saudi Arabia is much below the $80 level. That opinion comes from years of watching the country's movements in the oil business. I started paying attention to Saudi oil decisions back in 1974 when I was doing an independent research project in economics during my college years.
More cars and trucks will eventually have improved fuel efficiency. There will more hybrid and electric vehicles on the roads in the future. But there will also be millions more cars and trucks on the roads and the majority will still be propelled by gas-fired engines. Also, we can't just get rid of the hundreds of millions of existing autos and trucks already on the roads today. This is going to be a gradual process of adding newer, more fuel-efficient vehicles while replacing some of the older ones. But the total number will continue to increase by several million each year as new drivers join the ranks of consumers in emerging nations around the globe. That will continue to add an upward bias to world demand for oil for many years to come.
Vast new reserves are being tapped today that were technically unavailable in the past due to improved technologies such as horizontal drilling and fracturing techniques. Huge pools of oil have been and will continue to be discovered in deep waters and the now accessible Arctic Ocean. But much of these new reserves will not come on line for several years; some not for a decade or more due to political and environmental hurdles. All the while, existing reserves are being burned into oblivion.
Natural gas is abundant and provides new potential for fueling the electricity production in the U.S. and elsewhere. Yet, transportation issues and technology remain a bottleneck to tapping this huge source of energy for transportation and export. It remains my opinion that natural gas will not become an equal competitor for oil for as much as a decade; maybe longer, if at all. As progress is made on all fronts to lessen our dependency on oil, world demand will continue to increase inexorably higher until the breakthroughs necessary are found and implemented to bring down the cost and improve widespread access of competing sources of energy.
Thus, when oil prices drop into the low $80 range and the prices of stock in the oil patch follow downward, the long-term investor needs to add more oil to his/her portfolio. My assumption is that oil prices will continue to be volatile, but also grind higher with the average price per barrel going higher each year ending up with oil averaging in the $115 - $125 per barrel range by 2016. That is about 40 percent higher than the current price for oil. Add in the increased volume of barrels pumped and we can easily see earnings for the industry leaders rising by 60 percent or more by that time. Now add in the average dividend of 3.6 percent (also rising nicely) and we have the potential for exceptional capital gains with above average income to boot. So, let's look at which companies made my list and why.
My first entry is Chevron (CVX). I published an article focused on CVX in December 2011 and plan to hold onto the stock for the long term. Let's look at how CVX rates by the metrics I use.
Metrics | Chevron | Industry Average | Grade |
Dividend Yield | 3.7% | 3.9% | Neutral |
Debt-to-Capital Ratio | 7.0% | 14.8% | Pass |
Payout Ratio | 23.0% | 27.0% | Pass |
5-Yr Average Annual Dividend Increase | 9.0% | N/A | Pass |
Free Cash Flow per Share | $1.54 | N/A | Pass |
Net Profit Margin | 10.6% | 7.4% | Pass |
5-Yr Average Annual Growth in EPS | 11.5% | 3.0% | Pass |
5-Yr Average Annual Growth in Rev. / Share | -.02% | -.02% | Pass |
Return on Total Capital | 20.5% | 17.5% | Pass |
S&P Credit Rating | AA | N/A | Pass |
Nine passes and one neutral rating is almost as good as it can get. And the neutral rating was for having "only" a 3.7 percent dividend yield so I hardly count that as a miss. If we assume that the 9.0 percent average annual compounded rate of increase in the dividend continues over the next five years the earnings from this stock is very nice, indeed. That means that the $3.60 dividend would go to about $5.54 a share in five years. I believe that is possible because I expect earnings growth of eight percent per year over that period and the payout ratio is below the industry average providing room for the dividend to continue to grow slightly faster than earnings per share. I expect a total return from CVX of about 14 percent per year through 2016.
Exxon Mobil (XOM) is the granddaddy of all integrated oil companies. It topped the Fortune 500 list for 2011, trading places once again with Wal-Mart (WMT). A previous article I wrote focused on XOM and was used by the University of Missouri for an introductory class to Finance. XOM is positioning itself for the future by acquiring a huge position in natural gas reserves. The company knows a bargain when it sees one and natural gas reserves are about as cheap today as they will ever be. Management can afford to take the long-term view when investing in assets for future development. The company seems to be putting all pieces together now to take advantage of higher natural gas prices in the not too distant future. When that happens, XOM profits will surge, coming from another source added to the perennial increases from oil. Let's look at the metrics.
Metrics | Exxon Mobil | Industry Average | Grade |
Dividend Yield | 2.9% | 3.9% | Fail |
Debt-to-Capital Ratio | 6.0% | 14.8% | Pass |
Payout Ratio | 23.0% | 27.0% | Pass |
5-Yr Average Annual Dividend Increase | 7.6% | N/A | Neutral |
Free Cash Flow per Share | $2.60 | N/A | Pass |
Net Profit Margin | 9.5% | 7.4% | Pass |
5-Yr Average Annual Growth in EPS | 5.2% | 3.0% | Pass |
5-Yr Average Annual Growth in Rev. / Share | 9.4% | -.02% | Pass |
Return on Total Capital | 25.3% | 17.5% | Pass |
S&P Credit Rating | AAA | N/A | Pass |
XOM passed in eight categories, failed in one and got one neutral rating. The fail was because the dividend yield was more than 0.5 percent below the industry average, but at 2.9 percent it would have passed in most industries so I think we can let this one slide. The neutral came in the area of average annual growth in the dividend which was 7.6 percent, .04 percent below the 8 percent standard I require for a pass. But this is still a good growth rate and will reward investors well over the long term because of the consistency. Overall, the company is outstanding and regardless of its size I still expect a total average annual return of 12 percent over the next five years, including dividends.
Occidental Petroleum (OXY) is another company that I own shares in and plan to keep over the long term. I sell calls on this one to enhance my return so if I have the shares called away I may reconsider and get into XOM if the value proposition is better at the time. That is why I have more than one company to choose from in each sector category (not necessarily from each industry, though). If a stock gets called away I want several alternatives to choose from so that I can hopefully find the best value in a quality stock when I need to replace one that has gotten ahead of itself. Let's look at how OXY fared on the metrics
Metrics | OXY | Industry Average | Grade |
Dividend Yield | 2.7% | 3.9% | Fail |
Debt-to-Capital Ratio | 14.0% | 14.8% | Pass |
Payout Ratio | 21.0% | 27.0% | Pass |
5-Yr Average Annual Dividend Increase | 23.4% | N/A | Pass |
Free Cash Flow per Share | $0.16 | N/A | Pass |
Net Profit Margin | 28.5% | 7.4% | Pass |
5-Yr Average Annual Growth in EPS | 13.2% | 3.0% | Pass |
5-Yr Average Annual Growth in Rev. / Share | 8.8% | -.02% | Pass |
Return on Total Capital | 16.0% | 17.5% | Neutral |
S&P Credit Rating | A | N/A | Pass |
The same breakout as XOM; 8 pass, 1 neutral and 1 fail. Again the fail is on the dividend yield being too low relative to the industry average. Just because you can get a better yield doesn't mean it's a better investment. Just look at the rate of growth for OXY's dividend: 23.4 percent! I don't expect it to continue at that level but I do expect the average annual increases to be above 10 percent. I also expect the total return, including the dividends, to be over 12 percent per year over the next five years. OXY has made some great acquisitions and is looking for more as it continues to develop its assets to increase output consistently. The company is on a roll and I don't mind going along for the ride.
The fourth and last integrated oil company to make my list is BP (BP). I believe that worst is over and that the company will work its way back out of the huge hole caused by the Gulf oil spill. The company has reserves set aside to pay for any additional fines or obligations that may arise from the catastrophe. This is another situation similar to Exxon and the Exxon Valdez, just bigger. But the company has survived and is in good position to prosper in the future. The valuation is extremely low at this juncture and will take time to move back up to where it should be five years from now. Exxon survived to fight another day; so will BP, in my opinion. Let's look at how the company fares on the metrics.
Metrics | BP | Industry Average | Grade |
Dividend Yield | 5.2% | 3.9% | Pass |
Debt-to-Capital Ratio | 24.0% | 14.8% | Fail |
Payout Ratio | 17.0% | 27.0% | Pass |
5-Yr Average Annual Dividend Increase | -6.0% | N/A | Fail |
Free Cash Flow per Share | $1.49 | N/A | Pass |
Net Profit Margin | 6.8% | 7.4% | Fail |
5-Yr Average Annual Growth in EPS | 5.1% | 3.0% | Pass |
5-Yr Average Annual Growth in Rev. / Share | 7.7% | -.02% | Pass |
Return on Total Capital | 17.9% | 17.5% | Pass |
S&P Credit Rating | A | N/A | Pass |
The company rates three fails and seven passes. But at least two of the fails are all related to the Gulf spill and will correct over time: the dividend decreases and the net profit margin. The most interesting thing about this company is that it currently trades at a P/E ratio of just 4.9 compared to its peers which are trading at about 9 times earnings. Much of the industry has traded at an average P/E of 10 or 11 and will again. If BP can manage to raise its multiple back to the lower end of that range, which I do believe is possible given enough time; the impact on total return could get really interesting. I don't know if five years is enough time to fully recover, but a full recovery won't be necessary to get a 20 percent total return from this behemoth. I believe that 20 percent is achievable in that time period and intend to buy some for my own account soon.
In summary, I believe that the drop in oil prices is giving us a great opportunity to catch some great companies at good values. Part 6 will offer my explanations of why certain of the other majors didn't make the cut. Until then, thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!
Additional disclosure: I am considering adding shares of BP to my portfolio in the next 72 hours.
