By Stephen Leeb
The Complete Investor
While there will be bumps along the way, over the long haul best in-class oil stocks will be among the market's standouts as oil prices enter a new bull market. It isn't too soon to start accumulating these favorites listed below.
This is not your father's oil market. The sharp drop in oil prices masks deep strains that will become obvious once the world begins to grow at a fairly normal pace. Sooner than you might imagine, we'll see a severe mismatch between lagging oil supplies and rising demand.
New highs in oil will likely come well before new highs in the stock market, meaning investors should overweight oil (and other commodities). The main risk to oil stocks would be if global and U.S. growth remained in protracted downtrends. But the Fed's recent actions should spur U.S. growth, while growth in the developing world, which is even more relevant to oil trends, will likely accelerate as China, not encumbered by bad banks, pulls out all the stops.
Thus while there could be near-term bumps, over the long haul well-chosen oil stocks - such as the seven listed below - should be superb relative performers. Before reviewing these companies, though, let's look at why we think a sharp long-term rise in oil prices is virtually inevitable.
Emerging economies and supply constraints are at the heart of this forecast. Today emerging economies - those dominated by agriculture or manufacturing - account for nearly half of global economic output. The developing world's population is about five times greater than the developed world's, while its per capita consumption of material goods averages only 20 percent that in the developed world. The key point is that these emerging economies can't grow without increasing their consumption of oil and other vital commodities.
The heftier economic weight of emerging economies explains why the current period is nothing like the time after the last oil shock. In the late 1970s and early 1980s, worldwide oil consumption fell by around 10 percent. But more than 100 percent of that drop resulted from falling demand in the developed world, while demand in the developing world continued to grow without interruption. This time around, the developed world's demand will fall by around 11 percent. Yet the world's total demand for oil probably won't come down by more than 2 percent or so from its peak because of the far bigger role now played by emerging economies.
Now realize that if the U.S. begins to grow again even a little, oil demand here and in other developed countries will stop declining. Tacked onto strong growth in the developing world, that will be enough to send oil demand rising again - to where in a year or so it will pass its previous peak.
Will the supply be there? Go back to mid-2008. Oil prices were approaching $150, yet oil production was only marginally higher than at the previous peak in 2005. It is pretty safe to assume that whatever oil the world could produce at that time was being produced - no one was holding back. Validating this point is a chart of the EIA World Oil Production Forecasts which shows that predictions of oil production have been dramatically lowered over time. In 2007, for example, the U.S. Energy Department projected that in 2008, the world would have been able to produce nearly 90 million barrels of oil a day.
How much oil will the world manage to produce as demand climbs past previous peaks? Our best guess is probably less than was available in 2008. In 2008, with production maxed out, projects were being readied to bring more oil on stream, but these aren't likely to save the day. First, they'd need to make up for the natural depletion of existing wells and then some, a tall order - production in Russia, for instance, the world's biggest or second-biggest oil producer, appears to have peaked as depletion has taken its toll in the past couple of years. And second, as we've noted before, many of these projects have been shuttered as falling oil prices made them less economically viable, and it's always far harder to start a project up again than to shut it down.
In sum - look out for higher oil prices.
Now for our seven stocks. Three integrated oils make out list, including Chevron (CVX) (Growth and Income Portfolios) and ConocoPhillips (COP) (Income Portfolio). These giants stand out from other U.S. integrated oil companies because of their potential to increase production over the next five or more years. For Chevron, production growth should average close to 2 percent a year over the next five years, while reserve replacement should be nearly 100 percent. Most other majors have reserve replacement under 100 percent and in many cases production has been falling. Chevron's earnings will drop sharply in 2009 because of low prices but will likely rebound to record levels by 2011-2012. The growing and utterly secure dividend translates into a 3.9 percent yield, making Chevron one of the safest total return stocks around.
Conoco is the U.S. major with the greatest near-term obstacles, the reason being that a major chunk of Conoco's reserves are domestic natural gas deposits. Natural gas prices in the U.S. have fallen much harder than oil prices and currently natural gas reserves are more a negative than positive. Longer term, though, natural gas should at least keep pace with oil if only because it is cleaner. Conoco also has major exploration opportunities, but the results won't be apparent for five years or more. Despite these near-term issues, profits, down sharply in 2009, should rebound in 2010 and accelerate thereafter. The company's handsome yield will pay investors well as they wait.
Our third integrated oil is Brazil-based Petrobras (PBR), the major oil company with the best growth and reserve profile. In 2008 the company defined an offshore oilfield that could have well over 5 billion barrels. Even without this huge find, production is growing by better than 5 percent. If the massive offshore deposits are developed successfully, production could grow by as much as 9 percent a year over the next decade. Given rising oil prices, the long-term growth potential is enormous. Moreover, thanks to Brazil's natural endowment of farmland, the company also is a major biofuels producer. The chief drawback is that Petrobras is controlled by the Brazilian government, a potential disadvantage for foreign investors. But the risks are well worth taking, and Petrobras joins our Growth Portfolio.
The remaining four choices all come from the oil services sector. As oil supplies start to sharply lag demand, the need for oil services will become ever more leveraged to oil prices and to rising demand for oil. Our four picks are each best of class in their particular niche. Perhaps the most telling statistic is that while earnings for each of these favorites - Growth Portfolio's Nabors Industries (NBR), Schlumberger (SLB), and Transocean (RIG), plus the fourth, National Oilwell Varco (NOV), a stock that we're shifting from Fast Track Portfolio to Growth Portfolio - will decline in 2009, the drop will be far less than in previous periods when oil has dived sharply. And each is likely to see record profits early next decade given even a mild recovery in oil prices.
Schlumberger, by a wide margin, is the best and most dominant. Its services range from well testing to pressure pumping to seismic testing, and it's No. 1 in virtually every area it occupies. Some of its operations, especially those than maintain the health of existing wells, are highly recession-resistant. Others, though, such as exploration, depend on oil's price, which determines how much money companies will spend on oil services.
Historically, shares of oil services companies bottom before (1998) or at the same time as (2002) earnings do. Earnings, in turn, bottom after the bottom in oil prices. So if oil's recent lows in the mid-30s mark a bottom - a very good bet - Schlumberger's earnings should turn up in 2010, while the share price may already have turned around.
Of course, these are relatively near-term considerations. By early next-decade, if, as we fully expect, the world avoids a protracted recession or depression, Schlumberger should be flying high, in fact much higher than its previous highs. This points to a three-to-five year target well above 115. It will be a volatile ride but well worth taking.
Nabors is the world's largest land driller. In the past this would have meant enormous exposure to the U.S. land drilling market, where conditions are terrible and likely to remain poor probably well past the bottom in oil, since U.S. natural gas prices are unlikely to begin a sustained rise until 2010 or later. But in recent years this exceptional company has diversified into offshore drilling and dramatically broadened its international exposure, cutting its dependency U.S. natural gas. As a result, its earnings are more likely to follow the oil market. Yet the more than 80 percent decline in the stock far exceeds the fall in other oil-related equities - pointing to a sharp recovery and eventual new highs as energy prices of all stripes make new highs within the next three to five years. Because the Nabors' fairly high debt, we rate the stock as high-risk. But even under worst-case assumptions, it can easily cover interest costs, and the risks are well worth taking given the better than fivefold potential upside over the next several years.
As for Transocean, the key point is that the most likely places to find significant oil is in deep waters. The massive oil finds of Petrobras, for instance, are in the very deep waters off Brazil's coast. Deepwater projects are multiyear affairs, and cancellation of a project can defer payoffs by many years. As a result backlogs have remained strong for deepwater drilling, and pricing is down only 15 percent or so from its peak. Hands down, Transocean is the largest and most dominant deepwater driller. One of the surest signs of how dramatically the oil market has changed as we've neared or even passed production peaks it's the earnings surge by companies that hold the keys to these last chances for major discoveries. Since 2005, Transocean's earnings have advanced about ninefold. And over the next two years (again, barring a full-scale depression) profits are likely to remain steady, leaving the stock with a ridiculously low P/E and PEG ratio. Indeed, with long-term growth prospects of at least 15 percent, the company would be extremely cheap at its highs above 150. Moreover, free cash flow yield is likely to exceed 15 percent for the duration of the "slump." Transocean could multiply many times in the next five years and should be a core position in any energy portfolio.
Finally, let's look at National Oilwell Varco. This utterly dominant manufacturer of rig equipment and services has been nearly as insulated from the sharp decline in energy prices as Transocean. The company's huge backlog has remained intact, not surprising since cancellations could delay drilling projects by many years. Indeed over the longer term exploration can't increase without benefiting National Oilwell.
The only weakness in the nearer term picture - the servicing of existing rigs - will be a major strength later on. With many rigs on the sidelines. National Oilwell's servicing operations will likely suffer significant declines. But once oil recovers, this part of the company's business will turn around in a big way. Profits could drop a bit over the next year, but growth well above 15 percent is nearly assured longer term (again, barring a depression).
The stock is extraordinarily cheap. How cheap? Based on reasonable projections, free cash flow yield could approach 30. With little debt, this stock is in our medium-risk category, with a target many times its current price.
Editor's Note: Stephen Leeb is editor of The Complete Investor, P.O. Box 248, Williamsport, PA 17703, 1 year, 12 issues, $72. In this fact-packed newsletter you'll learn about Leeb's top investment recommendations: growth stocks, mutual funds, oil and energy stocks, currency plays, dividend stocks, zero-coupon bonds, treasury securities, value funds, precious metals, speculative stocks and more. You'll also learn about options, annuities, mega-politics and retirement strategies.
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