All hype aside, oil is a commodity. Investors should require extra discounts before investing in commodity companies. Essentially, there is nothing to prevent competitors from undercutting them. Investors should be rational and only invest in commodity producers if these stocks are trading at attractively low valuations.
The supply of oil and other energy sources could increase dramatically, and should give investors pause. Only incredibly compelling valuations should drive investors to oil producers.
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.
Let's quickly go through the five forces separately with commodity producers in mind:
- Rivalry of competitors. Commodity producers are rivalrous because their products are barely distinguishable and compete based on price.
- Customer bargaining power. You either drive around to find the cheapest gas or you know someone who does.
- 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.
- 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.
- 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.
Current Trends in Oil
The price of crude oil has been trading in the $90 per barrel range. The decrease is part of an ongoing trend in oil prices. Current weakness in oil prices has been blamed on the eurozone 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 driven by supply and demand. A decline in demand could surface through a consumer response to the persistent high price of gasoline. Energy supply has been bolstered by investment.
Malinvestment and Overcapacity
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 threat of renewables, and unexpected new challengers.
For example, 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 its processing plant's 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.
Iraq to Rival Saudi Arabia
Iraqi production may also add to supply, regardless of America's involvement.
According to U.S. State Department sources, Exxon Mobil (XOM) wants to quit its giant oilfield project in Southern Iraq by selling 60% of its stake in the project due to narrow profits from the $50 billion West Qurna-1 project. Exxon declined to comment on this matter. This could aggravate the country's internal tensions and hamper Baghdad's energy expansion plans. An exit from Southern Baghdad would depend on the company's ability to find a buyer for its stake in the West Qurna-1 project. An exit from this project would be in contrast to the deal signed with the autonomous North Kurdish region in Iraq, where there are better incentives, although the deal is deemed to be illegal in Baghdad.
Exxon stock has not had major movement upon the news and Iraq may have more at stake than Exxon. The West Qurna-1 project was hoped to triple oil output for Iraq, which would make its output rival that of Saudi Arabia. The dispute over oil contracts is part of a broader power struggle between Baghdad and Kurdistan for oil rights which is straining Iraq's uneasy federal union.
An exit from the West Qurna-1 project would be unusual for Exxon as it usually does not give up on its projects. Industry sources predict that Exxon would be replaced with buyers from China and Russia to teach the West a lesson and alter the diplomatic and political landscape. Chinese and Russian companies may not be technologically advanced though. U.S Secretary of State Hillary Clinton mentioned that Russian, American, French and Chinese companies all will be competing in Iraq.
Iraq could dramatically increase oil supply under international oil companies.
Drilling for Value
Exxon is not the cheapest integrated oil and gas firm:
Royal Dutch Shell
All the stocks on this list are cheaper than Exxon in terms of book value. Shell, which has more interesting growth opportunities, is cheaper than Exxon based on price-to-book, price-to-sales, and price-to-earnings metrics. BP and Statoil are also uniformly cheaper than Exxon.
At current prices, Shell, BP, and Statoil trade at attractive valuations, which are favorable to those of Exxon. Investors should consider these large oil companies as buy candidates since their valuations are sufficiently low for commodity producing stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.