The Oil Industry: Risk Vs. Reward

Includes: CVX, RDS.A, XOM
by: Catalyst Investments

OPEC. Tanker spills covering ducks in black tar. Environmental lawsuits. Every blizzard, flood and drought blamed on climate changes caused by fossil fuels. Images of J.R. Ewing-like Texas billionaires greedily taking advantage of hard-working Americans to add a few more millions to their inflated bank accounts. "Big Oil" decried as the enemy in stump speeches and election campaigns.

All of this is enough to scare many potential investors away from oil and natural gas producers. There are perhaps more risks in owning shares of energy companies than any other section. This may explain why the price-to-earnings ratios of these companies are currently well below the average of the Standard & Poor's 500, with the largest names selling at P/E ratios less than 10, including Chevron (NYSE:CVX) at about 8.5 and Royal Dutch Shell (NYSE:RDS.A) at about 7.7.

Media reports and political campaigns also tout the emergence of alternative, renewable sources of energy, leaving some to wonder if oil and natural gas companies have much of a future.

But the Clampetts didn't move to Beverly Hills because Jed discovered solar power. People are not flocking to North Dakota for high-paying jobs because a large biomass field was discovered. Energy needs will only increase as the population grows and more national and regional economies emerge. And despite the push for renewable fuel sources, experts project oil and natural gas will continue to be the world's main energy sources for the next century.

Industry Economics

Few industries are as impacted by economic movements than energy companies. After all, it is energy that fuels economic growth. Slower growth or even contraction reduces the need for oil, natural gas and other energy sources.

Like the world economy, energy companies are slowly recovering from the financial crisis of 2008-2009. The International Monetary Fund forecasts world economic growth of 3.5% in 2013, up slightly from 3.2% last year. Stronger growth of over 4% is projected for 2014. Growth could be stronger, the IMF says, if crisis risks do not materialize and financial conditions continue to improve.

The U.S. Energy Information Administration predicts global oil demand will grow 1.08% in 2013, compared with 1.2% growth in 2011 and 3% in 2010. The seven-year average annual demand growth rate before the recession was 1.6%.

While that growth rate seems small, the EIA calculates that it could lead to an increase of as much as 10% in oil prices, adding to the bottom line of energy companies.

Some analysts believe this is the time to enter the sector, as economic recovery should quicken and drive up demand in the next several years.

The PHLX Oil Sector Index (OSX) is up 39 percent from its 52-week low set in July 2012. Billionaire financier Carl Icahn has recently invested heavily in the sector, buying more than a 5% stake in Transocean and a 9% stake in Chesapeake Energy. Energy stocks make up about a third of his investment portfolio.

Production and Exploration

To profit from increasing demand, energy companies have to be able to find, procure and bring to market efficiently new oil supplies.

The oil and gas industry is typically divided into two sectors: upstream and downstream. The upstream oil sector, also known as exploration and production, refers to the searching for crude oil and natural gas fields, and the drilling and operation of wells. Downstream, on the other hand, refers to the refining of crude oil, and the marketing and distribution of products to the consumer (e.g. gasoline, kerosene, jet fuel, heating oil, etc.). [Some consider a third sector as midstream, which is the transportation and storage of oil and gas products, though most consider these as downstream operations].

About 90% of the earnings of Chevron , Exxon (NYSE:XOM), and most other oil companies comes from the upstream sector. Therefore, the depletion of oil reserves is one of the most significant problems facing these companies.

But finding new supplies is now more costly in many cases. That's because many of the largest reserves are in harder to reach places such as deep under water, in arctic regions or hostile regions.

Royal Dutch Shell has suffered delays in its plans to drill in the Arctic due to harsh conditions, and recently had its Kulluk drill ship run aground in the arctic waters off Alaska during a storm.

That's nothing compared with what recently happened in Algeria, when a terrorist group killed 80 people at a drilling facility run by BP and Statoil to protest France's military operations in Mali. With fewer reserves available in friendly nations, drillers are having to explore in locations that often have hostile feelings toward the perception of Western intrusion.

Finding fuel in hard-to-reach places requires more capital investment. And because the price of oil can fluctuate, it places a risk on large capital investments.

Take the case of Exxon's announcement that it is developing the Hebron oil field off the shore of Newfoundland. The company will spend $14 billion to extract the estimated 700 million barrels, and the first drops won't be recovered for another five years.

The current price of a barrel of crude oil is about $97. If the price were to hold steady, Exxon's $14 billion capital investment would generate $68 billion worth of oil. If the price per barrel from the field averaged $50, the investment would generate $35 billion, a much smaller margin. Then consider if the actual amount of oil came in under projections: 500 million barrels at $50 a barrel would generate just $25 billion.

Those hypotheticals don't account for unforeseen problems that may arise such as lawsuits by environmentalists, delays in drilling or another accident such as occurred in the Gulf of Mexico in 2010. These are risks every oil company investor has to consider.

One positive trend helping companies build domestic assets is hydraulic fracturing, also known as hydrofracking. The technique involves extracting oil and gas from rock formations. Though it's been around for decades, new technology has made the technique less expensive.

It has also made the U.S. an emerging player in global oil production. Companies in the U.S. can now tap into what is believed to be the world's second-largest reserve of shale gas, a fuel source found in sedimentary rock.

Because of this development, analysts claim the U.S. will become a net natural gas exporter by 2016 and completely energy independent by 2035. Yet because of the process, it has the potential to upset environmentalists, who fear contamination of ground water supplies and other impacts.

The Bottom Line

The EIA expects U.S. crude oil production to continue to grow rapidly over the next two years, increasing from an average 6.4 million barrels a day in 2012 to average 7.3 million barrels a day in 2013 and 7.8 million barrels a day in 2014. The International Energy Agency expects the U.S. to pull even with Saudi Arabia as the world leader in oil production by 2017 and to surpass the Saudis by 2022.

No matter where it's found and who uses it, oil and natural gas demand will continue to grow, and companies that spend wisely, explore diligently and produce and refine these fuels efficiently will reward investors for years to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.

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