Filling Up On Energy Bargains
Ken Kam; Marketocracy Marketscope, 10.14.05, 11:30 AM ET
(The biggest returns will be for the "Risk Takers" in the small growing companies like TDYH, IMO...)
SAN FRANCISCO, CALIF. - I never like paying too much for gas or for stocks. With gas prices well above $3 in California, I’m always looking for gas stations with the cheapest gas. It’s the same with energy stocks.
For months, I’ve been telling you that energy stocks should be a big portion of your portfolio. They are the most strategic component and are smart risk management as a hedge if the economy takes a dive from high oil prices. But if oil prices continue to rise without slowing the rest of the economy, this will be your best performing sector again.
In May, when oil prices dropped 18% and most “experts” were declaring that the oil run was over, I told you to load up. Since then, oil prices have jumped 41%. Now, we’re seeing a similar pullback as some people take profits. But, the same supply/demand imbalance and the minuscule supply buffer problems we’ve talked about still exist. So, as prices fall, this is a great time for you to pick up some energy stocks at a good price.
Like gas stations, some energy stocks are cheaper than others. Let me tell you about three types of energy stocks I’m most excited about.
Safe ways to find oil.
Some companies drill in the deepest oceans and deal with unstable and unsavory governments to find new oil fields. But higher oil prices are making it profitable to explore for oil much more safely--in fields that were previously considered exhausted.
It turns out there is a lot of oil left in an “exhausted” oil field. When the price of oil is less than the cost of extraction, an oil field is considered exhausted and the proven reserve for that field is set to zero. However, when the price of oil rises above the cost of extraction, magically, the oil reserve reappears on the balance sheet.
At today’s oil prices, a lot of exhausted oil fields are economic again. Oil companies, especially those with a high percentage of exhausted oil fields, have been able to increase their reserves without looking any further than their own books. Companies like Chevron (nyse: CVX - news - people ), Exxon Mobil (nyse: XOM - news - people ) and ConocoPhillips (nyse: COP - news - people ) have a lot, and their stock prices already reflect that.
Today’s oil prices are spurring a lot of activity to reopen old fields. It makes a lot of sense to drill where you know there is oil: You have a pretty good idea of what it will take to get it out of the ground, and you already have the infrastructure needed to get the oil to market.
So, a better investment is in the companies that provide the services needed to get exhausted oil fields back into production. They are doing a booming business. Here are a few of my favorites.
Houston-based Grey Wolf (amex: GW - news - people ) is a contract driller, operating primarily along the Gulf Coast and into Oklahoma. Grey Wolf has already put back on line 37 of its 40 rigs that had shut down due to Rita. The stock is up 50% in the past year and trades well below its 52-week high of $8.60 hit on Sept. 30. The company’s market capitalization is $1.4 billion.
San Antonio-based Pioneer Drilling (amex: PDC - news - people ) is a contract driller, but does its business on land in Oklahoma and throughout Texas and the Rocky Mountains. Being land based allows Pioneer to benefit from higher oil prices, but buffers it from the shutdowns and service interruptions that plague drillers on marine platforms. The $705 million market-cap company is up more than 100% in the past year.
Refining profits.
For decades, the refining industry has been only marginally profitable. But late last year, when capacity utilization for the 148 active refineries in the U.S. started to push above 90%, it was easy to see that if the economy grew much at all, or if there were any outages for any reason, refining capacity would become a bottleneck and profit margins would greatly improve.
The hurricanes knocked 13 refineries offline and Wall Street is now abuzz with talk of the shortage of refining capacity. Some of our largest holdings and biggest winners this year are refining companies and they have performed exceptionally well. Valero (nyse: VLO - news - people ) recently acquired Premcor (nyse: PCO - news - people ) to become the largest refiner in North America. Since the beginning of the year, Valero is up about 135%. Shareholders of Premcor who accepted Valero stock in the merger are up 120% this year. The transaction leaves Tesoro (nyse: TSO - news - people ) as one of the few large independent oil refiners left. Tesoro is up 86% this year, but its below market P/E ratio of 14 makes it a potentially juicy acquisition candidate.
No one wants to live near a petroleum refinery.
Every time someone proposes to build a new refinery, citizens’ groups are formed to file lawsuits under federal environmental laws and state regulations to halt construction. They have been so effective that no new refineries have been built in the U.S. since 1976. Rather than try to run the regulatory gauntlet to try to build a new refinery, it’s been safer, cheaper and easier to buy an existing one. This does not result in any new capacity coming online, but every time an acquisition occurs it seems to establish a new and higher value for existing refineries.
The price gap between sweet and sour crude is widening.
A big reason why Valero has been so profitable is because it is one of the largest refiners of heavy “sour” crude. Valero decided long ago to go after this segment of the market, and it has turned out to be a brilliant strategy. Why? Because there is a widening price gap between heavy “sour” crude and light “sweet” crude. The price gap has ranged between $9 and $20 this year and is currently over $15 per barrel. Last year the price gap averaged around $11, and in 2003, it was only $7.
Refiners churn out the same end products (gasoline, heating oil, distillates, etc.) using either feedstock, but not all refiners have the equipment to process heavy sour crude. That costs a little more (it costs Valero only $1.5 to $2 more for refining sour versus sweet), but those that can are cashing in on the price difference and their stock prices reflect that.
The price gap is widening because there is a big supply/demand imbalance. The vast majority of the world’s oil reserves (75%) are sour crude. Only 25% is sweet, but most of the current oil production (40%) and most of the world’s refineries are geared to sweet. In China, where much of the growth in oil demand is generated, 80% of refining capacity is dedicated to sweet crude. When OPEC turned on 2 million barrels a day of excess production, the world’s refiners turned their noses up because it was largely sour crude.
The big shortage is of sweet crude--that’s where demand is growing, and that’s the price of oil we see announced. In fact, OPEC recently announced that worldwide production of sweet crude may have peaked and is now on the decline. Meanwhile, the world is awash in supply of sour crude without many refiners able to process it. It will take a long time for refining capacity to change.
So, with growing demand for gasoline and other refined-oil products driving the prices and profits for all refiners upward, and with companies like Valero reaping the rewards of a widening price gap between sour and sweet on the upstream side, sour refiners like Valero are going to continue their monster returns.
Energy demand isn’t going away, so the largest portion of your portfolio should be in energy stocks. Take my advice and fill up on some cheap energy stocks while their prices fall back.
Excerpted from the Oct. 2005 issue of Marketocracy Marketscope.
AI
