Oil & Gas companies continue to have a rough and confusing 2012 as we see investor concerns over shrinking economies in Europe, sovereign debt, and weak growth from China take their toll on crude oil prices. This is worsened by a production hike in Saudi Arabia, which was implemented months ago to keep oil prices tame and the world economy intact.
Iran strongly opposed the measure, and despite asking repeatedly for the Saudis to avoid a production hike, it happened. Now the effects of a production hike by OPEC, and a widespread embargo on Iran (enforced by the US and European powers) has cut Iran's oil exports to a 20-year low. Combined with the recent drop in oil prices, there is no doubt that the Iranian government is hurting (financially speaking).
Great Potential In US Oil Production
This heavy political tension initially drove bullish speculation on crude in 2012, but the aforementioned weakness in global economic conditions and boost in Saudi/OPEC production has more than offset these gains. Adding more downward pressure this year is the impressive improvement in US production, which is illustrated in the following chart:
(click to enlarge)
According to the EIA, US oil production hasn't been this high in 14 years. Great news for certain parts of the US economy, somewhat depressing news for oil bulls with futures contracts, or positions in tracking funds like US Oil (USO).
The strong production helps the theory that the United States' oil reserves are much bigger than originally thought (think up to 3.5 trillion barrels). There's less and less data supporting the oil-scarcity theme that politicians have propagated for years.
Hypothetically, if the US maintained its current consumption of oil (somewhere near 7 billion bbl/year) and could extract all of its estimated 3.5 trillion barrels of oil, we could support our petroleum needs for half a millennia.
I suppose that's an overly optimistic scenario, so let's just consider technically-recoverable and shale oil reserves are given the same consumption rate. We still get almost 200 years of self subsistence (or the option to export large quantities of it).
So while American oil producers may not see significantly higher oil prices in the near future, higher production volume would more than offset that problem in company earnings. This reliance on high volume production seems much more plausible as we develop better extraction methods and expand our estimates of US natural oil reserves.
While the idea was to briefly highlight the potential for America's petroleum industry, there is much more research that can be done.
Why Producers Can Ignore European Drama
A recent article on crude oil included interesting commentary by TOTAL S.A. (TOT) chief executive and chairman Christophe Margerie. After an explanation of how the supply-shock induced by Saudi Arabia and other OPEC nations was a temporary effect, he went on to discuss the effects of financial trauma in the Eurozone.
The situation in Europe isn't that worrisome, Mr. de Margerie said, as he believes that the single currency won't disappear. Yet he didn't rule out that the scope of the euro zone (and therefore of the euro) might change, in a veiled reference to a potential exit of Greece from the bloc.
Such an event is unlikely to dent the group's business directly, he said.
But any strengthening of the euro does dent the group's refining margins, which are expressed in U.S. dollars and have been suffering from overcapacities in Europe. "When the euro is lower to the dollar, it's better for our margins," he said.
-Geraldine Amiel, MarketWatch
Margerie claims that Europe isn't a big deal for the petroleum producers, and I concur for a few reasons. Oil demand in Europe has always been stagnant (or slow) - it's really China and the United States that we're watching. Second is the likelihood that Europe's economic contraction(s) are currently priced in.
Then, there is the possibility that the disaster is lessened through intervention or averted altogether. Whether it's done through quantitative easing or not, bearish speculation on crude oil should certainly ease if the markets return to a more normal state.
Another idea suggested by Margerie is that refiners (especially in Eurozone countries) are the main victim of a weak euro. I am more interested in oil production rather than refining operations myself for this reason (among others). Weak demand makes refining operations dangerous and potentially unprofitable investments due to the potentially narrow spreads between crude and refined oil products.
Targeting US Petroleum Production, Dividends, and Returns
So, let's now consider the two concepts above. The United States has shown very encouraging signs in recent production, and reserves may be much bigger than we think so we want some exposure to that specifically. We'll also assume that the Eurozone problem can be largely ignored, and we'll focus on production rather than refining.
Lastly, let's also add some dividend growth. It is extremely pleasant to watch the returns compound over time.
Narrowing it down, I've constructed a little portfolio of 5 petroleum stocks with unique characteristics. Together, they should provide a nice overall spread on US oil production.
1.) Occidental Petroleum (OXY)
In Q1 2012, the company broke a new record in quarterly oil & gas production. In recent years, OXY has also produced a smooth trend to the upside in its total revenue despite volatility in oil & gas prices. Its stock has declined over 10% since the start of the year, which already accounts for the slowdown in China and some side effects of Eurozone stagnation.
Dividends have also been growing rapidly. From 2010 to 2011, the cumulative annual payments increase from 1.47 to 1.84 (about 27% more). Occidental also delves in chemical production and midstream operations, but the bulk (about 80%) of its business is derived from oil & gas production.
If oil and/or natural gas prices recover in the next few years, I think Occidental will report shockingly positive figures for revenues and earnings based on its performance in the current environment. OXY starts our portfolio with a nicely-priced mix between yield and growth.
2.) Marathon Oil (MRO)
Marathon is an oil & gas company that has recently been bruised a bit more than other energy & petroleum names. MRO has struggled with earnings since 2010, and cut its dividend since 2011. There are clearly a few flaws to work with, and recent performance has not been very encouraging.
Although their sale of their refining business, now known as Marathon Petroleum (MPC), drove some investors away it offers us a more targeted play on Marathon's upstream operations. Going back to Margerie's commentary, we are not interested in refiners in this environment.
The company does offer some things that we are looking for. According to the company's most recent estimates, about 42% of total energy & petroleum production is from the United States. Sales volume of liquids grew 8% in the last quarter, while revenue from the sector dropped about 16%.
This provides our necessary exposure to the US production, while implying major improvements in operating margin later. We also have rapidly increasing liquid and gas production from Marathon's Eagle Ford shale play, which was an expensive acquisiton that should ultimately reward Marathon for its efforts.
Although it has been cut recently, MRO still offers 2.7% yield. I expect this to be increased dramatically if Marathon can eventually sell its crude oil at a more reasonable price. This is especially true with natural gas, which is barely profitable for Marathon to extract right now.
3.) Baker Hughes (BHI)
Baker Hughes is a very volatile driller that makes up for its very stingy dividend increases with growth potential. The company does about half of its business in North America, and is seeing a favorable trend in reported revenues. Earnings lagged in early 2012, which implies a drop in operating margin due to huge improvements in revenue (which was up 18% in 12 months preceding Q1 2012). Digging quickly through the same quarterly report, I found a scapegoat:
"As previously disclosed, margins in North America were lower than the fourth quarter due to challenges in the Pressure Pumping product line"
-Baker Hughes CEO Martin Craighead
An interesting statistic for Baker Hughes stock is the PEG ratio, which is .51 according to Yahoo. This is based on forward estimates of the company's earnings (which are notoriously optimistic), so the implied upside should be taken with a grain of salt. BHI should introduce a little more growth potential into our portfolio.
4.) Halliburton (HAL)
Veering further away from the dividend-focused companies we arrive at Halliburton, which derives about 60% of its revenue from North American operations. This company is a more extreme version of Baker Hughes, in that it doesn't seem to care about dividends but offers undeniable value for its price. The one bright side of the weak dividend leaves a payout ratio of 11%, which leaves a lot of breathing room for dividend hikes.
Cash flow and revenue have been the most telling sign of this company's business growth, with large, consecutive annual increases since 2009. I think Halliburton can produce some stellar EPS growth in future years if they can improve their ~15% operating margins. The PEG ratio is an incredibly low .39 based on average analyst estimates. Like shares of Baker Hughes, shares of HAL should provide explosive appreciation potential based on its valuation.
5.) ConocoPhillips (COP)
ConocoPhillips remains a great E&P pick for almost any type of investor, and rounds out our portfolio nicely with its diversity. It has a high, ever-increasing dividend (currently ~4.9%) to raise our overall yield, and looks ready to make record sales revenue despite the depressed prices in crude oil & natural gas.
ConocoPhillips also earns 34% of its production-derived revenue from the United States, which makes COP fit into our US-heavy theme better than other oil giants.
With equal weight in all five stocks you should have a portfolio that yields 2.6% in dividends and generally grows in proportion to increases in the price of oil/gas and US production.
