Dreams of return on equity can turn into nightmares when excessive capital expenditures or new technologies expand production capacity and compete away potential profits. Unfortunately, myriad new technologies and expanding capacity are cause for energy investors to lose sleep.
Malinvestment and Overcapacity
Remember the cries of "peak oil" from energy bulls? Speculation in the 2008 commodity bubble provided substantial funding for new drilling projects and investment in new energy technologies. This funding catalyzed the rise of natural gas fracturing, the long-term of threat of renewables, and unexpected new challengers.
Seaborne liquefied natural gas plants are emerging as a new threat to energy sector profitability. The largest LNG producers in the world, led by Royal Dutch Shell (RDS.A), have figured out how to move their processing plants to floating barges so they can tap into remote underwater fields. Shell has plans to build a floating LNG plant in South Korea by year end 2012. This will be the world's biggest floating LNG plant, and will weigh six times more than the largest aircraft carrier. About 5,000 workers are expected to build this vessel, and it is expected to cost about $13 billion.
This will be a huge transition for Shell from a land-based infrastructure initiated roughly 50 years ago, when Shell provided the technology for the first commercial LNG plant. These plants may offer a cost savings in addition to geographical flexibility since a land-based facility costs about $20 billion to build.
Many of Shell's rivals, including France's GDF Suez and Malaysia's Petroliam National, are also planning to turn gas into liquid at sea. This technology could unlock a virtually untapped resource. Most of the world's largest natural-gas deposits have been found out in the ocean over the last 10 years.
In addition to hydraulic fracturing, this technology further substantiates natural gas as a cheap substitute for petroleum oil on a global scale. This substantiates a structural change in the energy markets.
This structural change will win out over speculation over monetary easing. Loose monetary policy has prompted some analysts to predict a 3% increase in commodities this year. However, there are concerns of a correction since policy makers aren't doing what is needed to bolster economic growth in a time when supply is expanding.
The index is almost 2% lower since an announcement by the European Central Bank stated that they planned an unlimited bond-purchase program and almost 4% below the level when the Federal Reserve announced QE3.
Independent oil and gas companies must trade at cheap price multiples to compensate investors for the threat of increased supply and lower energy prices. For example, Apache (APA) is attractively priced at $87 per share. The firm's 1.98 price-to-sales ratio is in line with today's prevailing market multiples. Apache shares are trading at an attractive 10.37 price-to-earnings ratio, lower than the 14.1 average of the S&P 500 index. The price-to-book multiple of this stock is 1.1, cheaper than the 2.05 S&P 500 average. The firm's reasonable 0.33 debt-to-equity ratio demonstrates that the firm is not overleveraged. After this year's broad market rally, investors might enjoy purchasing Apache since it is actually down 3.9% over the past year.
An even steeper 11.2% decline in price over the past year has made Chesapeake Energy (CHK) an even more attractive buy at $20 per share. This stock's 1.04 price-to sales ratio is significantly less than the 1.29 average of the S&P 500. Chesapeake shares are trading at a bargain 6.43 price-to-earnings ratio, less than half the 14.1 average price-to-earnings ratio of the S&P 500 index. The stock trades at a discount to the accounting value of its net assets with a 0.74 price-to-book multiple. Analysts expect that the firm's earnings growth will accelerate with five-year estimates at 7.8% per year, considerably faster than -11.8% annualized earnings growth over the past five years. The 1.79% dividend yield of the stock is comparable to the 1.64% 10-year treasury yield. Future dividend payments are likely because the company pays out 0.11 of earnings as dividends, so earnings could drop considerably before dividends must be cut.
Shares of Devon Energy (DVN) are not trading low enough at $62 to compensate investors for this risk. The shareholders of this independent oil and gas industry large cap stock have seen a 0.3% rise in price over the past year. 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 2.24 ratio. Devon shares are trading at an attractive 10.33 price-to-earnings ratio and a price-to-book multiple of 1.12, both of which are below the S&P 500 average.
The threat of a supply glut has not been priced into the shares of all energy companies. Shares of EOG Resources (EOG) are not trading low enough at $115 to compensate investors for this risk. 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 2.73 ratio. EOG shares currently trade at a high 22.49 price-to-earnings ratio, a higher value than the 14.1 average of the S&P 500 index. Shares trade at a 2.33 price-to-book ratio which is near the 2.05 S&P 500 average.
A 21.7% jump in price over the past year has left Enterprise Products Partners (EPD) stock too expensive for investors. At $54.40 this independent oil and gas industry large cap stock trades at a high 19.86 price-to-earnings ratio. Moreover, the 3.93 price-to-book multiple of this stock is higher than the 2.05 S&P 500 price-to-book ratio. Investors would be better off investing in an S&P 500 index fund.
Income investors should not be fooled by the hefty 4.67% dividend of EPD. The firm's 0.92 dividend payout ratio is shaky since this leaves very little room for failure and scarce funds for reinvestment. The dividend yield might not be sustainable.
Royal Dutch Shell itself offers a growth-at-reasonable-price opportunity at roughly $72 per share. At a 0.47 price-to-sales ratio, 8.55 price-to-earnings ratio, and 1.27 price-to-book multiple, Royal Dutch Shell trades at lower price multiples than the S&P 500 average. As a vertically-integrated energy company it is resistant to changes in commodity prices. As a leader in seaborne LNG plants Shell is better positioned to reap benefits from its growth.
Investors should consider purchasing stock in Royal Dutch Shell, Chesapeake Energy and Apache. These companies are trading at compelling valuations, which should provide limited downside in an energy glut.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.