Oil Majors' Divergence from Crude at Record

The other day, I was asked how to play high oil prices in this market. One person suggested the obvious way to play things was with oil services, but I've heard those stocks touted so much and so long that I feel compelled to look upstream to the E&P majors as an alternative.

The example I used was ConocoPhillips (COP), which has long been noted to trade at a discount to Exxon (XOM) and Chevron (CVX). I worked through the implied market price of the reserves held on Conoco's balance sheet; it came out to about $15/barrel. With $22/barrel in production costs – though only half of that is cash, the rest relates to DD&A – it makes much more sense for Conoco to buy back stock instead of exploring for new reserves, which cost just over $30/barrel to find and bring online in 2007. Here are the calculations.

I ended by noting that an E&P ETF (PXE) had been gaining momentum relative to the Oil Services HOLDR (OIH), and suggested buying PXE against a short on OIH.

Doing similar calculations for Chevron, one arrives at a market value of $18.90/barrel – keeping in mind, that value is only derived from enterprise value divided by reserves, and does not include other assets the company has such as refineries. Still, it looks like Chevron has lower production costs per barrel than Conoco, although I have a feeling things aren't exactly comparable due to tax differences.

Moving to Exxon, the market is valuing their proven reserves (all figures in oil equivalents) at $20/barrel. This is in-line with what I'd anticipate, because Exxon has a lower cost per barrel of production at $7.14 against Chevron at $8.58 – don't things look so orderly under these scenarios? Still, Conoco's average cost of production stripping out non-income taxes is in the low-to-mid $7s per BOE, leading to my thinking that the stock is inexpensive relative to other major oils.

I wrapped up my thoughts thusly: 

 

So why do I prefer the E&P majors over the oil services companies? Valuation is a part of it, but given that substantially more shareholder value is created through share buybacks as opposed to reinvestment (i.e., where the services companies make their money), E&P isn't going to be the first capital spending priority of the oil majors, especially considering that E&P costs per barrel continue rising, while the stagnant market values of the oil majors have resulted in value compression in favor of buybacks.

 

… and then suggested a long PXE position against a short OIH position. But forget OIH for a moment, and concentrate on the market pricing of PXE relative to oil prices since the start of 2007:

That chart hits at the heart of what I'm saying; relative to crude prices, the oil majors are down over 30%. While I think part of this is due to a realization of value problem because it will take a lot of money flow to budge the valuations on Exxon, et al., and those dollars seem allocated directly to commodities for the time being, there is only so long the price-value discrepancy can exist, especially when the companies themselves are out buying back tens of billions in stock annually with their massive cash flows. While it might take some suspension of disbelief to envision XOM at $130 for a market cap of $700 billion, at these crude price levels it isn't that far of a possibility.

Of course, if XOM does get there, their stock wouldn't look so cheap and suddenly the value creation equation might shift in favor of the oil services, but that's a ways off and we should have plenty of time to reassess if and when that comes to fruition.

One last note: for those of you interested in an even longer perspective, we're currently sitting at an all-time record low for PXE relative to oil:

Comments

[fxtrader07]

good article but i don't understand why you trade the majors against OIH? Your charts show their undervaluation versus the price of crude - so the logical position would be long COP (XOM...) and short USO?!

[jjason]

You state that values are "relative to crude prices". So, if crude oil prices come down then oil company stocks come down.

When oil futures speculators are driving up the price of a barrel of oil, what do you think of Senator Durban's efforts to limit oil futures speculation?

Also, since the CFTC is not doing their job, what will happen to oil stocks when the FTC or the Department of Justice gets involved in exposing the scam on US consumers?

For an article exposing oil speculators go to:

www.star-telegram.com/...

If you want to read Professor Michael Greenberger's report on June 3, 2008 to the US Senate Committee titled "Energy Market Manipulation and Federal Enforcement Regimes". Go to:

www.commerce.senate.go...

Then ask Congress to change the laws that are creating high oil prices through manipulation in the worlds commodity exchanges.

[Mmarrkk]

Short answer to jjason: If "senator" Durbin is saying it or doing it, I am against it!! He's a goofy leftist who can't be trusted for anything other than lining his own pocket. You'll need to start your posts off with someone with more credibility if you want to be taken seriously. And that would eliminate a large number of senators and congressmen. Particularly ones with a "D" after their names but it includes a huge number of those with "R" as well. And "I" for that manner.

[Trooper]

jjason, you have a long line of forbears that is always ready to blame the speculator for anything that they don't like. He's a very convenient scapegoat, since being more or less non-existent, he can't defend himself. It was the short-sellers that caused the depression, etc.

Much of the buying in the oil futures market lately has been shown to be hedgers buying back their short positions. I.e., oil companies who thought that oil was already at a peak back at $90 sold short to lock in or hedge their production.

Hedging is the opposite of speculation: its purpose is to reduce risk not make a bet. If you ban or hobble the futures market, you will increase market risk and volatility, not reduce it.

And how will Congress regulate the "world commodity exchanges"? I think the EU might just take a little exception to that.

[jjason]

Trooper and Mmarrkk...You both obviously did not follow my links and read the article and the report.

Are you speculators?

And as for Senator Durban, he didn't read Professor Greenberger's testimony either. This problem began in 1999 and created Enron's fraudulent behavior. The problem is that posters like you are not willing to listen to experts who do know better.

[Trooper]

jjason, you obviously didn't read my post, so we're even, I guess.

Except that I did actually read your links and they are nonsense.

And no, I gave up speculation years ago. 99.9% of speculators lose money in the long run to the hedgers. But so what? If I was sure I could make money by buying oil futures, I would do it in a heartbeat, and so should anyone else. The fact is that speculation is a losing game and only people that know nothing about it believe that they move markets and can win in any consistent or predictable way.

And those people, such as yourself, who have this fanciful belief, provide a ready market to charlatans such as Durbin.

And what makes you think a speculator is not an "expert"?

[sharksm]

These morons who want to end "speculation"... and "hedging" and buying "futures" are too dumb to realize that oil is commodity traded world wide. Speculators and hedgies can buy and sell on the London or other exchanges, whereas eliminating such activity here will have no effect on priceds, demand or supply. The Congress is the problem, not the solution to high energy prices. To tell OPEC to up their production while refusing any more production increases here in the U.S. is idiotic and just typical of the hacks we send to Congress election after election. The people who blindly continue to vote for their Congressional Reps and Senators who refuse to allow more drilling for oil deserve $8.00 gasoline, not $4.00. And they will get it, should Obama get elected.

[Bobcheesedoodle]

It's amusing that sharksm is blaming future prices for gasoline on Obama when it is the republicans who are joined at the hip with the oil industry. Let me respond with something equally as stupid. If you vote for the McCain the sky will fall.

[User 218886]

ok