Solving the riddle of undervalued oil company stocks

"Oil company shares languish even as oil prices stay high."

This has become a comment lament, even a truism in the past year, as oil company executives scratch their head in puzzlement over why Wall Street does not like them better when both oil and gas commodity prices continue to enjoy a bull run.

Merrill Lynch notes that the share price of the group of majors that it tracks has fallen 2% since the beginning of the third quarter, while the S&P 500 has advanced 3%-despite the fact that oil prices have remained mostly above $30/bbl since OPEC's June 21 decision to raise oil production quotas by 708,000 b/d.

"We believe that major oil share price performance has suffered from investors reducing positions in response to a perceived peak in oil prices," Merrill Lynch.

In fact, the analyst contends that declining oil prices are not incompatible with strong performance in major oil shares. It uses as an analog the majors' strong oil share performance despite falling oil prices in 1996-97.

In that period, major oil shares at first failed to respond to a spike in oil prices from $18/bbl in January 1996 to $24/bbl that April.

"Despite improving fundamentals and declining inventories, equity markets were concerned that the expected return of oil exports from Iraq under the UN-monitored 'oil-for-food' program would crater oil prices," Merrill Lynch said.

Consequently, oil company stocks languished throughout the first half of 1996. But in mid-1996, Iraq and the UN announced an accord on renewed oil exports, which slashed oil prices by about $4 to $20/bbl. But this had no effect on oil shares. As the year wore on, the continuation of squabbling between Baghdad and the UN in fact delayed the onset of Iraqi exports. That caused crude oil stocks to deplete, forcing oil prices back up to more than $26/bbl. When Iraqi exports finally did start up, rebuilding inventories early in 1997, that sliced $6 off the price of oil again. Not only were majors' shares unaffected by that price drop, they actually began to rally once oil prices had apparently stabilized at $20/bbl.

Merrill Lynch thinks that the current equity market environmenta resembles 1996-97 in two key ways: 1) concerns that higher supply will lead to oil prices below $20/bbl and 2) concerns that major oil shares will fall as oil prices drop from peak levels.

"Like 1996-97, we believe that the major oil shares will react positively to the elimination of uncertainty about OPEC supply management and stabilization of oil prices above $20/bbl."

The analyst thinks that major oil shares are especially attractive because they are discounting oil and gas prices at only$18/bbl and $2.50/Mcf.

This will become increasingly apparent as Saudi Arabia and its few OPEC colleagues with spare productive capacity are ultimately forced to increase production to keep oil prices from exceeding the upper end of the group's agreed price band. That will only further expose the capacity limitations in most OPEC countries, says Merrill Lynch, and that equity markets will increasingly embrace the view that OPEC capacity constraints will lead to a higher "normalized" oil price over the next 3-4 years.

The analyst thinks that many of the major oil company shares have an upside potential, vs. current levels, of as much as 25-50%.

"We believe that this share price appreciation potential will be realized as investors increasingly embrace our investment thesis that the energy sector has completed only the first year in what we believe will prove to be a 4-5 year industry up-cycle," it said.

Access to capital

That points to a growing concern among many industry watchers: Even if oil and gas prices remain high, will the industry have access to enough capital to do the job it needs to find more oil and gas to replace production? Or will we see another frenzy of mergers and acquisitions as companies with a surge of cash flow take advantage of the bargain stocks being neglected by Wall Street-in some cases, the companies buying their own stocks?

This in part explains the lag in big capital spending increases that typically accompany a sustained rally in oil and gas prices combined with a tight market outlook (the other factors being skepticism over the rally continuing and a need to pay down debt). But it cannot be forgotten that, even if companies were to ramp up spending quickly, they also face an investment community much less sanguine about the current state of commodity prices and much more attentive to the cleanliness of one's financial "house." So investors are "cherry-picking" stocks more these days and not just rushing headlong into oil just because oil prices are high-which is as it should be. In the last sustained boom, there was too much good money chasing the bad, and not enough attention paid to a company's bottom-line fundamentals.

Then there remains a further concern: Coming out of another collapse of an industry already working with low staff levels, there is a great worry that there simply will not be enough qualified staff to carry out the needed E&P work. In other words, even if the companies had the capital and believed prices would remain in a comfortable range, they may not have the human wherewithal to do the job-hence the argument for a sustained 4-5 year up-cycle.

Remember the bumper sticks praying for another boom, followed by the pledge not to screw it up this time? Assuming a genuine supply crisis is not the result, that bumper sticker may yet prove to be a prophecy.

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Latest Prices as of August 18, 2000

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