By Richard Moroney
Dow Theory Forecasts
The ability to distinguish short-term noise from sustainable trends, while always useful, is especially crucial in the energy sector. In the short term, energy stocks tend to move together based on the price of oil and natural gas. Over longer periods, however, returns on energy stocks will diverge considerably based on industry exposures, company performance and strategy, and takeover activity.
The energy sector has retreated broadly since the end of January because of a pullback in oil prices, a sharp drop in natural-gas prices, and reduced refining margins. Also, many are concerned that today's above-normal inventories portend a sharp drop in energy prices later this year. Considering the sector's huge share-price gains over the past three years, its reaction to the recent spate of bad news is understandable. But we're making no changes to our energy recommendations, for the following reasons:
We're not hugely exposed. Energy stocks represent 13.1% of our Buy List, versus about 9.5% for the S&P 500 Index. Our Long-Term Buy List has 8.4% in energy stocks, plus another 6.0% in energy/utility hybrids.
The sector provides a nice hedge for portfolios. When oil and gas prices rise because of political strife or natural disaster, energy is typically the only sector that benefits.
Energy stocks still shine in our Quadrix(r) stock-rating system. Based on average Overall score, the most important score in Quadrix, the energy sector ranks best.
While the energy sector is no longer uniformly cheap, attractive values are still available. Five of our six recommendations in the energy sector earn Quadrix Value scores of 85 or higher, ranking them among the cheapest 15% of U.S. stocks. Our energy recommendations are attractively valued relative to historical norms - even based on the most pessimistic profit estimate for 2006 and 2007.
Oil and gas prices may be under pressure in the near term, but the long-term picture for energy prices remains favorable. Inventories of oil and oil products are about 10% above long-term norms for this time of year, while inventories of natural gas are about 50% above normal. So, further price weakness would not be surprising. But OPEC's spare production capacity is at all-time lows, while non-OPEC producers are at capacity. With demand growing steadily and producers struggling to grow reserves, a return to oil price below $40 per barrel seems unlikely.
By diversifying with best-of-breed energy companies, we should be able to outperform the sector. Based on valuation, operating momentum, and market position, our recommendations compare favorably to industry peers. Below are our favorites in four energy groups.
ConocoPhillips (NYSE COP $59), the nation's third-largest energy company and second-largest refiner, represents our top pick among integrated oils. Refining and marketing account for about one-third of total income. In April 2005, the company announced a five-year, $3 billion plan to expand its ability to refine heavy crude oil, which trades at a considerable discount to light crude.
In December, ConocoPhillips agreed to buy Burlington Resources (NYSE BR $89), a producer of natural gas, for $35.6 billion in cash and stock. The deal, expected to close in the first half of 2006, will make ConocoPhillips the largest producer of natural gas in North America. In February, the company completed its acquisition of a German refinery. The company acquired a 16% interest in Russian oil company Lukoil in 2004 - and plans to increase its stake to 20% by year-end.
ConocoPhillips' acquisitions have not been popular with investors, as many would have preferred to see excess cash returned to shareholders. But the expansion moves could pay off in a big way if energy prices remain above historical norms. Moreover, at six times expected 2006 earnings of $9.75 per share, the stock trades at a discount to its five-year average and its peer group. Even based on the lowest estimate for 2007 earnings, $5.43 per share, the P/E is just 11. Over the last 10 years, the trailing P/E has averaged 13. ConocoPhillips is a Focus List Buy and a Long-Term Buy.
As the world's largest land drilling contractor, Nabors Industries (NYSE NBR $64) has the size to service the largest contracts. Nabors, our top drilling pick, has about 600 land-drilling rigs and 870 land-workover and well-servicing rigs, as well as 62 offshore rigs.
Recent results have been strong. High energy prices have led exploration-and-production companies to drill more wells, which has lifted rig-rental pricing. Despite a pullback in natural-gas prices, management said Feb. 6 it has seen no slowdown in activity and continues to expect strong demand against a limited supply of rigs. The company has secured three-year contract commitments on 82 land rigs out of 100 currently under construction.
Nabors drills primarily in North America but is working to increase its exposure to such international markets as the Middle East. About 15% of total revenue is generated abroad. Consensus estimates project per-share-profit growth of 55% this year and 30% next year. At 10 times estimated 2006 earnings of $6.21 per share, the stock trades well below its five-year forward average P/E of 22. Nabors, trading at just 10 times the lowest estimate for 2007 earnings, is a Buy and a Long-Term Buy.
Oceaneering International (NYSE OII $53), a provider of underwater services to the oil-and-gas industry, is our favorite pick in equipment and services. In 2005, per-share earnings jumped 49% on a 28% revenue gain, with all segments posting higher profits. Results were boosted by projects stemming from hurricane-related damage, which should continue into 2007. Deepwater drilling, construction, and production are expected to remain strong.
The company has been increasing its prices, adding to its fleet of remotely operated vehicles, and improving utilization of assets. At year-end, the subsea-product backlog was up 150% compared to the beginning of the year. Oceaneering is making headway on installing new manufacturing capabilities at its facility in Florida. Significant capital investments - more than $275 million over the last two years - should help drive growth.
Consensus estimates project per-share-profit growth of 33% this year and 13% next year. The stock trades at 17 times estimated 2006 earnings of $3.11 per share, slightly above its five-year forward average P/E of 16. Oceaneering, a relatively aggressive energy holding, is ranked Buy.
With U.S. refiners operating near full capacity, Valero Energy (NYSE VLO $54) is benefiting from attractive margins. The largest refiner in North America, Valero has posted 10 consecutive quarters of record profits - an impressive feat given the volatile nature of its industry. December-quarter earnings more than doubled to $2.00 per share, as revenue soared 68%. Continued strong global demand, coupled with limited increases in refining capacity, should support healthy margins this year.
Valero has a successful record of integrating acquisitions, and its robust cash flow will allow for more deals if opportunities present themselves. Otherwise, cash will likely be used to pare debt, fund dividend increases, and repurchase shares. In 2005, the company spent nearly $600 million on stock buybacks.
Weather, imports, refinery shutdowns, and volatile oil prices can impact refining margins, making profit estimates guesswork. Margins have narrowed so far in 2006, but a heavy maintenance schedule is expected to reduce capacity and bolster margins in the June quarter. For full-year 2006, per-share earnings estimates range from $5.85 to $8.50, with the average of $7.62 implying 13% growth. For 2007, the low estimate is $4.43 and the high is $8.75. The 2007 average is $6.97, up from $6.57 a month ago.
While Valero seems unlikely to beat earnings expectations so easily in coming quarters, the stock already discounts a more challenging environment. In fact, based on the lowest 2007 profit estimate, Valero trades at a P/E of 12 - in line with its 10-year average trailing P/E. The stock is a Buy."
Editor's Note: Richard Moroney is editor of Dow Theory Forecasts, 7412 Calumet Ave., Hammond, IN 46324, 1 year, 52 issues, $279, www.dowtheory.com.
