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Investors should require extra discounts before investing in the equity of commodity companies. Essentially, there is nothing to prevent competitors from undercutting them. Investors should be rational and only invest if these stocks are trading attractively low valuations.

Current Trends in Oil

The price of crude oil recently dropped to below $90 per barrel. The decrease is part of an ongoing, multi-month downward trend in oil prices. Current weakness in oil prices has been blamed on the euro zone crisis as economies continue to struggle in Europe and may speculate that the Euro will weaken relative to the dollar more than it has over the past two years. However, some analysts believe that the steady descent in oil prices may simply be a part of crude oil's ultimate demand destruction, a consumer response to the persistent high price of gasoline.

Will supply decline as well? The reported sales of crude oil were lower and oil companies have reported their oil supply is going down. Analysts reported that this week there should have been a gain in oil of several million barrels. Oil companies themselves point to the reduction of imports as an explanation for where the declining inventories. But others are more skeptical of achieving a balance between supply and demand. Summit Energy analyst Jacob Correll said, "Even though inventories fell, I don't think that's enough to overwhelm what's already going on in the market."

Understanding Profitability

Porter's five forces is a framework for assessing the profitability of an industry's firms. Industries whose firms have more bargaining power with customers, more bargaining power with suppliers, low rivalry between firms, few substitutes for their goods, and high barriers to entry tend to be more profitable.

Commodity industries are bad for profitability. Let's go through the five forces separately:

1) Rivalry of competitors. Commodity producers are rivalrous because their products are barely distinguishable and compete based on price.

2) Customer bargaining power. You either drive around to find the cheapest gas or you know someone who does.

3) Threat of new entrants. New competitors could spring up without any proprietary barriers to entry. If you want to manufacture iPhones you need permission from Apple (AAPL). No permission is needed from any gas company if you want to produce petroleum products.

4) Supplier bargaining power. Suppliers like land-owners and skilled laborers can demand high prices. This may sound like a non-issue until you realize that as a shareholder, everyone who works for the company is diverting money from your ownership interests. When times are good salaries go up, and when times are bad it's hard to take them down.

5) Availability of substitutes. Consumers can buy cars with better mileage. Opting for a car with a 38 mpg engine instead of a 19 mpg engine allows consumers to cut their gas consumption by 50%. That's bargaining power. What's more, consumers can opt to carpool.

There is also the specter of high-pressure fracturing which haunts oil companies. This is a very scary supply shock, should natural gas-powered cars become popular.

Drilling for Value

The best investment among these candidates is Chevron (CVX), which recently traded around $117 per share. The shareholders of this major integrated oil & gas industry large cap stock have enjoyed a 12.3% climb in price over the past year. Shares offer a dividend yield of 3.09% which is much higher than the 1.64% yield of the 10-year treasury bond. Future dividend payments are likely because the company pays out 0.24 of earnings as dividends, so earnings could drop considerably before dividends must be cut. At a value of 0.92, this stock trades at a fraction of the S&P price-to-sales average multiple. Chevron shares are valued at a compelling 8.68 price-to-earnings ratio, a value which is significantly lower than the 14.1 average of the S&P 500. The price-to-book multiple of this stock is 1.76, cheaper than the 2.05 S&P 500 average. The firm is also mostly equity financed, so the stock is solid financially.

According to Paul Sankey, a Big Oil analyst for Deutsche Bank, "We think it makes no sense whatsoever to be cash positive in this interest rate environment." And with $21 billion in cash on hand, Chevron is in a good position to acquire another company for growth. Chevron looks very solid internationally, but has some chalking up to do here in the U.S. in terms of shale acreage. While Chevron could acquire players like Hess (HES), Apache (APA), or Chesapeake (CHK), I think it would be better served with more focused companies like Range Resources (RRC), which has a heavy position in the Marcellus shale, or Continental Resources (CLR), which is heavily rooted in the Bakken.

Investors can also find value in Exxon Mobil (XOM) by buying shares near $91.50. The shareholders of this major integrated oil & gas industry large cap stock have seen a 9.9% rise in price over the past year. Shares offer a dividend yield of 2.49% which is likely dependable based on its 0.21 payout ratio. At a value of 0.85, this stock trades at a fraction of the S&P price-to-sales average multiple. Exxon shares are valued at a compelling 9.61 price-to-earnings ratio, a value which is significantly lower than the 14.1 average of the S&P 500. Shares trade at a 2.59 price-to-book ratio which is near the 2.05 S&P 500 average. The firm's low 0.1 debt-to-equity ratio reveals how the firm has an exceptionally strong balance sheet.

Exxon Mobil recently announced an agreement to buy Bakken assets in North Dakoa and Montana from Denbury Resources (DNR). Exxon has agreed to pay $1.6 billion in cash, and an estimated 28 MMBoe proved developed reserves. Exxon will also receive an estimated 100,000 net undeveloped acres in the core of the Bakken/TFS play, along with 75,000 net undeveloped acres in the Tier 2 area of the Bakken. While Exxon will have to spend nearly $5 billion to develop these new assets, the quality is very high. I think Exxon will continue to look for new opportunities to acquire additional acreage.

ConocoPhillips (COP) is not as compelling a value at $57. This stock's 1.07 price-to sales ratio is higher than both Exxon and Chevron. Its 11.04 price-to-earnings ratio is also higher than those of either stock.

Similarly, Occidental Petroleum (OXY) at $86 per share does not match the value of Exxon or Chevron. Its 2.51% dividend yield is lower than dividend yields from either firm. Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.29 while this stock has a much higher 2.88 ratio. Occidental shares are trading at 11.09 price-to-earnings ratio which is lower than the 14.1 average of the S&P 500 index but still higher than either Exxon or Chevron.

Conclusion

The "peak everything" scenario is great as a Hollywood movie premise, but does not justify bubble valuations. Instead, I consider cheap valuation as an investment criterion. Chevron and Exxon Mobil pass this test and are acceptable oil industry investment candidates.

Source: Cheap Valuations Make These 2 Oil & Gas Stocks A Buy Now