Investing In The Energy Sector: Ignore The U.S. Majors, The Best Value Is Abroad

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Includes: CEO, CVX, E, SPY, XOM
by: The Independent Investor

It is always unfortunate when the best run and well-respected companies make horrible investments. While an investor's primary goal is obviously to maximize returns, it always feels good to invest in a company that is well-respected and well-managed.

While the S&P 500 and its tracking exchange traded fund, SPY (NYSEARCA:SPY), has fallen nearly 10% since mid-April, many leading stocks in sectors such as technology, energy, and the industrials, have fallen over 15% from highs earlier this year. Even Apple (NASDAQ:AAPL) has fallen more than 15% from its previous high of nearly $640.

Still, by far, the worst-performing sector over the last several months has been energy.

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Oil prices bottomed at around $75 dollars a barrel in October of 2011, and topped out around $110 dollars a barrel in early March. While oil prices rallied nearly 40% during the previous, nearly six-month rally, in most risk asset classes, oil prices have dropped nearly 30% in the last two months.

While, obviously predicting oil price movement is very difficult, stocks in the energy sector have fallen much harder than the S&P 500 and most of the broader indexes over the last two months. Given the massive decline in most oil producing and oil service stocks, I think it is worth looking to see if there is value in the market today.

The most important metric to me when gauging an oil company's business model is looking at what the company's long-term oil production numbers are likely to be. Obviously, oil companies rise and fall with the price of oil. Still, companies that can consistently show strong and increasing production increases can maintain cash flow and earnings even if oil prices plateau.

The two largest integrated oil companies in the United States are Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX). While Exxon-Mobil and Chevron have excellent track records of growing earnings and dividends over the past 10 years, it is important to note that oil prices have nearly tripled since 2003, when oil was trading at around $30 a barrel.

While oil prices may continue to rise in the coming years as developing nations continue to grow at faster rates and new oil is increasingly difficult of find, it's unlikely oil prices will triple from today's levels anytime soon.

This is exactly why I question the long-term returns that Chevron and Exxon-Mobil can offer. Today, Exxon-Mobil gets over 60% of the company's production from natural gas in the United States, and the company grossly overpaid for XTO, which the company bought when natural gas prices were more than double what this commodity is trading at today. Exxon-Mobil's year-over-year production was basically flat, at 1%.

Likewise, Chevron, which gets nearly two-thirds of its production from oil, has also had problems increasingly oil production numbers as well. Chevron recently reported a 3% drop in international oil production, which is where the company get three-fourths of its total oil production. Chevron has consistently had trouble increasing the company's oil production numbers, and even when oil reached a short-term peak of around $115 a barrel, the company was only able to raise its dividend by 9%. While Chevron did report a recent increase in the company's oil reserves, SEC guidelines are very lenient in how reserves are reported, and Chevron's ability to extract this oil in the near term will be seen over time.

So where are the companies consistently growing oil production. I think they are in Europe and China today.

Eni S.p.A. (NYSE:E) is the largest oil company in Italy, with a market capitalization of around 70 billion dollars. ENI S.p.A. has had troubles raising its oil production numbers of recent because of the conflict in Libya, but the Italian government stayed out of the Libyan civil war, but Libyan oil production is now are prewar levels. ENI S.p.A. is well-positioned in Libya and West Africa, where extraction costs are as low as $2 dollars a barrel, and most grades of crude are the highly sought after sweet crude.

ENI S.p.A. has consistently reported industry-leading oil production gains of 2-3% a year over the last decade, management has consistently raised its dividend by 10% a year, and the ENI S.p.A. reported a huge recent natural gas discovery in Mozambique. Natural gas prices overseas have held up very well because of the scarcity of the resource.

CNOOC (NYSE:CEO) one of China's largest producers of oil and natural gas, with a market cap of nearly $80 billion dollar. While the company has also seen by a recent 6% year-over-year drop in oil production largely from the company's operations in a Chinese field in Penglai being suspended, CNOOC also reported major recent oil finds in the Penglai area, as well as other Chinese provinces. CNOOC's recent drop in production came as the company increased capital expenditures by nearly 60% this past year, and the company has made a number of major recent discoveries in China, including a significant new find just a couple week ago off the country's southern Liaodong Bay in Bohai.

CNOOC, along with other Chinese oil companies, has the advantage of having exclusive rights to explore the Chinese coast, and oil finds by foreign companies can only be developed if these companies partner with Chinese operators. CNOOC also recently guided to nearly 6-10% annual production growth over the next decade, and the company has raised its divided by nearly 13% on average the last five years.

To conclude, while the biggest companies in any industry often get the most attention, the best value often requires more research. While, the U.S. majors are very well-run companies, most of their new oil discoveries have come in deepwater, where the cost to extract oil is very high. While many leading foreign markets, such as China and Europe, have lagged he S&P 500 by a significant margin this year, not all companies are created equally, and the best value is often found in the most beat-up markets.

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