Big Oil's Run-Up Isn't Over Yet

ExxonMobil just posted an annual profit that tops the gross domestic product of Slovenia. So why do many analysts and big investors think the four-year party in energy stocks is over? The problems, as they see them, include everything from unusually warm weather in parts of the U.S. to Saudi Arabia trying to put the screws to Iran.

Exxon (symbol XOM), the nation's biggest company by market value, on February 1 reported a $39.5 billion profit for 2006. But fourth-quarter profits actually dipped 4% from the same quarter a year earlier. Some analysts see Exxon's 2007 profits dropping to $36 billion (about the same as Ecuador's gross domestic product).

Look no further than the gas pump to see why the experts are nervous. In some states, a gallon has dipped below $2. On the international stage, Saudi Arabia has signaled it wants to keep the price of oil at $50 to $55 a barrel, down from a high of $77 in July. Some analysts think the Saudis want to hobble Iran by robbing it of petro profits. Another possibility is that the spike in prices last year scared the Saudis and other OPEC producers, who worried that high prices would spur greater energy efficiency and the development of more sources of alternative energy.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just ~~$107.88~~ $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

https://cdn.mos.cms.futurecdn.net/flexiimages/y99mlvgqmn1763972420.png

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

That consumption has slowed in key regions is a fact. The International Energy Agency reported recently that oil use by industrialized countries actually fell 0.6% last year. And although worldwide consumption grew about 1% in 2006, it grew twice as much in 2005. To add petroleum distillates to the fire: Oil inventories have risen and earnings estimates have fallen for many energy companies, not just Exxon.

But consider two numbers that may trump all of the above. Even though the price of a barrel of oil, which closed at $59.02 on February 2, has fallen 23% since last summer, the American Stock Exchange Energy index has dropped just 4%. (Exxon closed at $75.54, up 0.6% for the day and down just 4% from its 52-week high.)

The reason for this disparity is simple, says John Dowd, manager of Fidelity Select Energy fund: "When you have stocks that are very cheap, they don't go down when the commodity goes down." And oil stocks are certainly cheap. On average, stocks of big oil companies trade at 9 to 10 times estimated 2007 earnings. By contrast, the price-earnings ratio for Standard & Poor's-500 stock index is 16. P/Es for cyclical industries tend to be low, especially when business is humming. Further depressing oil-stock P/Es is the possibility that investors assume that crude prices will fall below $50 a barrel.

If oil does drop below $50, don't expect it to stay there for long. And once investors realize that, energy stocks should resume their ascent. Tim Guinness, London-based manager of Guinness Atkinson Global Energy fund, believes oil will trade between $50 and $70 a barrel for the next few years -- and then head for even greater heights.

Dwindling supply is the main reason analysts such as Guinness predict that energy prices will stay high. Guinness says companies operating in West Africa, Mexico, the Caspian and Brazil are having "huge problems" getting oil out of the ground. Fidelity's Dowd says that while the number of U.S. drilling platforms has almost tripled since 1999, gas production remains about the same.

The problem goes even deeper when you look longer-term. Charles Maxwell, senior energy analyst at Weeden & Co., says that while non-OPEC countries produce 60% of the world's oil, most, including the U.S., have reached peak production. In a few years, non-OPEC production will start to decline. By 2010, Maxwell says, we may face this Oliver Twist scenario: Begging OPEC with our hat in our hand, "Please sir, I want some more."

Maxwell is bearish on energy stocks for 2007. It's certainly not surprising to see caution among Maxwell and other analysts after the sector's phenomenal run -- in the past four years, the Amex index is up 180%. But given the fundamentals, we agree with analysts who think energy stocks remain cheap.

Exxon, however, isn't on the bargain basement list. Though it earns more than $100 million a day, it trades at about 12 times estimated 2007 earnings.

Among big oil, you won't find a better value now than ConocoPhillips (COP). Although the company's main reserves are in the U.S. and Europe, where production is waning, it's tapping new sources in the Middle East and Asia. Russia may be a dicey place to operate, but ConocoPhillips' 20% stake in Russian oil giant Lukoil has great potential. Analyst Jacques Rousseau of Friedman, Billings, Ramsey calls ConocoPhillips a stock with "great value" based on a P/E of six times his 2007 earnings forecast of $10.60 a share. The stock closed at $67.29 on February 2, virtually unchanged for the day.

Drilling on the ocean floor is getting tougher as explorers look for oil and gas deposits in deeper and harsher seas. Oil companies now pay dearly for this expertise, and Noble (NE) is an industry leader in know-how. On a single one of its "jackup" rigs -- platforms supported by legs that lower like jacks -- Noble will earn about $180,000 a day from new contracts. That's twice the rate of late last year. At $75.76, the stock trades at less than 9 times estimated 2007 earnings. Moreover, the company just increased a share buyback program.