The energy sector, specifically oil and gas, has been a less than desirable area for investment lately. This is primarily due to the volatility of oil and gas prices. Yet, I do see great opportunities within this sector, especially for the long term. In the following article, I will hone in on four companies, Chevron (CVX), Exxon Mobil (XOM), BP (BP), and Royal Dutch Shell (RDS.A), which are selling below their 52-week highs and have strong balance sheets.
Chevron is America's third largest company, and second largest oil and gas company after Exxon Mobil. Chevron is certainly in no position to overtake Exxon anytime soon, as Chevron's revenues in recent years have usually been about half of Exxon's. Chevron is doing a lot of things right, but that is not the purpose of this article. Chevron is a defendant in several multi-billion dollar cases, and I am writing today to gauge those cases and assess the risks they pose to Chevron.
Any integrated oil and gas company is going to be in court on a routine basis. But Chevron is also the subject of matters that are far from routine. On the other hand, Chevron is not a typical company. It has operations in six continents, and in the first quarter of 2012, it earned nearly $6.2 billion, for a trailing 12 month total of over $27 billion, or $13.62 per share. It has $20 billion in cash, and a debt level so low it is only 7 percent of capitalization. Largely because of falling oil prices, analysts are looking at 2012 full-year earnings of about $13 per share, which I believe in such a low oil price environment is an optimistic estimate. Chevron's operating margins of 17% and profit margin of 11.5% in the trailing 12 months beat its competitors such as Exxon Mobil, whose operating margin was 12% and profit margin was 9% in the same period, and BP, whose operating margin was 7.6%, and profit margin was 6.3%. Seemingly, Chevron is the best of the large, integrated oil and gas companies; but is it?
All upstream and integrated oil and gas companies are going to be unable to meaningfully grow this quarter, due to the precipitous decline of oil prices that shows no real sign of abating. A just released inventory report that was expected to show a fall of about 500,000 barrels instead showed a rise in domestic inventory of 100,000 barrels. It was thought that reduced imports would cause the inventory to fall. But increased domestic drilling, along with reduced usage in the United States caused the rise, and West Texas Intermediate crude prices fell further to about $78 per barrel. Chevron realized an average price of about $102 per barrel in the first quarter. There is no way that integrated oils, whose upstream operations are far larger than their downstream components, can adapt to the low-cost environment as quickly as costs have dropped.
Adding to Chevron's current headaches is South America. The issues go back some 50 years, to when Texaco had operations in Ecuador. The years at issue were from 1964 through 1990. In the course of drilling, Texaco would place its waste products in unlined pits located not far from the headwaters of the Amazon River. Those are about the only facts upon which all parties agree. A review of the websites for the Plaintiff group and Chevron shows the depth of the factual disagreement of the underlying case. But Chevron acquired Texaco, and the indigenous population near the area of the dumping started showing increased disease rates, and the scars on the environment are obvious.
The very public nature of the dispute, and sophisticated social media use belie the "David versus Goliath" character that plaintiffs seek to portray. Predictably, the Ecuadoran trial court issued an $18 billion judgment, and the judgment was affirmed by the appellate court. The Ecuadoran Supreme Court indicated it would hear the case, and that is where we sit right now. There is so much public fervor in Ecuador over this matter that in shipping the documents from the trial court to the Supreme Court, Chevron used trucks with security escorts.
It is one thing to obtain a judgment in Ecuador, but nowadays Chevron has no assets in that country. Plaintiffs have taken their collection efforts to Brazil, which probably makes more sense than any other country from which to collect. Chevron has substantial assets in Brazil, and the political and regulatory climate toward Chevron is not at all positive in that emerging economic giant. The Brazilian action will not begin in earnest until there is an actual conclusion in Ecuador, presumably in the Supreme Court action.
Chevron has earned Brazil's enmity due to two different offshore oil leaks where a Brazilian prosecutor, Eduardo Santos de Oliveira has sued Chevron and its partners, including state oil company Petrobas (PBR), for a sum of $22 billion. Oliveira may be doing what he is more for political reasons than for anything else, but Chevron is in a world of hurt in that country, and it is the perfect country for the Ecuadoran plaintiffs.
Chevron has the cash and resources to settle the Ecuadoran case, yet it may be that pride will prevent that from happening. These cases will be a drag on Chevron until resolved one way or another. And these sorts of actions also sap management's attention and energy.
Companies that are running highly efficiently and profitably have limited upside. South American matters aside, Chevron is at the top of the class. But one company I see as overlooked in this sector is Royal Dutch Shell. Its operating margin and profit margin are 11% and 6% respectively are substantially lower than Chevron's. But this Anglo Dutch giant is taking one step all but guaranteed to increase its margins and profitability. That is, it is expecting liquefied natural gas to be sent via new pipeline to Royal Dutch's shipping terminal in British Columbia in order to transport gas from North America to Asia. A new, $4 billion pipeline is expected to be operational within eight years. The reason exports make sense; in the United States and Canada, is natural gas is selling at about $2.70 per mmBTU. In eastern Asia, the same product was selling recently for about $17 per mmBTU.
It takes a bit of a leap in faith to invest in big oil companies in the face of declining oil prices. But neither oil, or natural gas prices, will stay depressed indefinitely. All oil companies, even the best ones, are selling well off their 52-week highs, have strong balance sheets, and generous dividends. Having a bit of a contrarian streak is not a bad thing for the long-term investor, and I believe now is a great time to go long in this sector.