Negative Trend for Oil Exploration and Production Stocks

Key Points:

• Falling oil and natural gas prices are causing brokerage analysts to reevaluate their forecasts on E&P companies.
• During the past two weeks, earnings estimates have been cut on 41 E&P companies.
• Positive revisions still outnumber negative revisions by a large margin, but the trend is clearly turning negative.

Since early July, crude prices have dropped by more than 20%. Natural gas prices have dropped even more. Fears of weakening demand helped to deflate the energy bubble.

The demand concerns have been caused by revised forecasts for the energy sector and slower economic growth worldwide. Earlier this week, the International Energy Agency proclaimed an easing to the tight global and supply balance that had played a significant factor in driving oil prices higher. Wednesday, Japan said that GDP fell 0.6% last quarter.

Barring a supply disruption, such as a hurricane hitting the Gulf Coast, current trends suggest a further drop in oil prices.

For investors holding onto oil stocks, especially exploration and production (E&P) companies, this creates a problem. As I have previously stated on our Zacks Elite web site, brokerage analysts are likely using crude price targets of $110 to $120 per barrel in their profit forecasts.

Estimate Revisions

Starting last year, as the oil bubble inflated, brokerage analysts were forced to constantly adjust their models to reflect higher crude prices. This resulted in numerous positive revisions on oil exploration and production (E&P) companies. As long as oil remained above the prices used in the profit models, it was logical to believe that more positive revisions would occur.

Now the situation is reversing, with oil headed below what many analysts have factored into their models. Therefore, it is now logical to assume that profit forecasts will be lowered.

Profit Forecasts Starting to Get Cut

The numbers suggest a trend towards lowering profit projections has started. During the past two weeks, 81 full-year earnings estimates have been cut on E&P companies.

Andarko Petroleum (APC) has received the most negative estimate revisions with 7 covering brokerage analysts cutting forecasts. Though APC exceeded second-quarter earnings expectations with profits of $1.76 per share, its revenues were a bit light.

Forest Oil (FST) follows closely behind with 6 negative estimate revisions. Again, better-than-expected second-quarter earnings have not stopped brokerage analysts from lowering their full-year profit projections.

Denbury Resources (DNR), EOG Resources (EOG), Quicksilver (KWK) and XTO Energy (XTO) all have had five brokerage analysts cut their profit projections in the last two weeks. Earnings forecasts have also been cut on 35 other E&P companies.

Some Disagreement Does Exist, But The Trend Is Negative

As negative as this seems, the aggregate trend in estimate revisions for this industry group remains overwhelmingly bullish. The revisions ratio is 1.67, reflecting 214 positive revisions and 129 negative revisions. (Within recent weeks, 6 brokerage analysts have raised their full-year forecasts on APC and 3 have increased their profit projections on FST.)

The problem is with the trend, however. When oil prices peaked last month, the revisions ratio for E&P companies stood at 17.2, reflecting 241 positive revisions and 14 negative revisions.

Oil could fall to between $80 and $100 per barrel, barring any supply disruptions. Were this to happen, more earnings estimates could be trimmed on E&P companies.

This is not a case of anything being inherently wrong with the fundamental strength of these companies, but rather a change in the short-term risk/reward ratio. We have reduced our exposure to the energy sector in the Zacks Elite Focus List portfolio with the intent of adding back some oil and natural gas companies at lower prices.

For those wanting exposure to the oil and natural gas sectors, integrated oil and oil machinery and equipment stocks might be safer over the short-term. (We hold ConocoPhillips (COP) and National Oilwell Varco (NOV) in our Focus List and Top 10 portfolios, respectively.) Those unwilling to endure short-term volatility may want to consider waiting for oil and natural gas prices to settle, however.

Related ETFs

There are various funds with exposure to the energy sector. Two E&P pure plays are iShares Dow Jones U.S. Oil & Gas Exploration & Production (IEO) and First Trust ISE-Revere Natural Gas Index Fund (FCG).

Comments

[fxtrader07:]

analysts were slow to revise upward when oil went up and were slow to revise down when oil and gas tanked. however, most oil and gas stocks never reached bublle valuations of any kind. in fact i would very much challenge your notion of an 'energy bubble'. what we have seen is the first(!) echo of a dollar and credit bubble starting to unwind, reflected in a rise of formerly depressed commodities (overvalued dollars bought too much of a barrel of oil). Now we see a healthy correction. Most e&p companies can live with oil at 80-100. heck, cop and apc and others will make a ton of money from $90 oil.
valuations are reasonable to dirt-cheap in this sector as long as you do not ecpect oil to drop below 70 for any sustained period of time. Howvere, if that were to occur, I suspect the entire stockmarket would crater by 50%+ as that would signal a global depression unheard of since the 1930s

2008 Aug 14 07:04 AM

[peacefulval...:]

While your article accurately notes the recent decline in crude and natural gas prices, it contains serious shortcomings. First, most E&P company stocks did not rise proportionately with the sharp rise in energy prices we witnessed in the earlier part of the year. Analysts wisely discounted a portion of this rise as a bubble-type phenomena. Second, E&P companies are more accurately measured by multiples of cashflow rather than earnings. Anadarko, for example, produced discretionary cashflow of $2.31 billion in Q2---the equivalent of approximately $19.62 on an annualized basis. This means the company, at $57 per share, trades at a stunningly low 2.9x cashflow. Third, there is extreme disconnect presently between equity values an Net Asset Values (ie: reserves) with many E&P companies trading at roughly 50% to 60% NAV. In summary, there is very little downside in the higher quality large E&P companies even with a return to what many industry experts would consider sustainable pricing: $80 crude and $8 natural gas.

2008 Aug 14 08:15 AM

[whisperonth...:]

Oil won't go back to $50 or $70 or even $90/barrel anymore than bread has gone back below $1/loaf.

2008 Aug 14 09:25 AM

[freefall51:]

I hate to admit this. But whenever I followed Zacks advice as a subscriber I lost money. Zacks is most mostly a momentum - go with the flow -service. Once the flows has been identified the market turns around on a dime. Better to buy conviction and keep the view on the horizon.

2008 Aug 14 10:11 AM

[huangjin:]

Analysts value E&P companies on earnings estimates, investors value the present value of reserves plus future production. What do I care about natural gas prices in October when I am looking at production and reserves in 2010 and beyond?

2008 Aug 14 10:11 AM

[Timothy Stolz:]

It's always of interest reading what Zacks has to offer and then watching the markets to see if the majority of the "investors" followed that advice. Most mass movements of the majority point of view are usually wrong.
My interpretation of the "Estimate Revisions" is that they are probably too bearish. The oil & gas sectors seem to be primed for stock price and earnings stabilization with a period of steady growth soon to follow.
The "present time" affords a unique and unusual opportunity to acquire equity positions in very valuable companies. Take advantage of it!

2008 Aug 15 08:19 PM

[Gigem77:]

The market does not apply a large multiple to energy shares. For example, DVN is expected to make 12 bucks this year. But their PE has been 10 or below all year. Apply any reasonable multiple to 12 and look at today's price.

We have a 10 year uptrend in crude, which is still very much intact. But all of the punditry writing for seekingalpha is from daytraders trying to extrapolate a paradigm shift from 5 weeks of correction. The analysts revising earnings are getting twitchy also. I agree with Mr. Stolz, this is an great opportunity to buy.

2008 Aug 15 10:01 PM

[mkreisel:]

COP is cheap even at $60 oil.

2008 Aug 17 01:55 AM