The energy analyst returns! One of Slope's readers, a very experienced energy analyst, has been kind enough to once again pen a guest column. As before, if you'd like me to forward a note or simply your email to the Energy Analyst, just drop me a line. Enjoy!
The next several days are critical for energy, and perhaps the overall market. As mentioned previously, Tuesday April 22 marks the expiration of the May oil futures contract. How the commodity closes could provide important insight whether the next stop is $110 per barrel or $125.
Regardless, oil and the equity markets are at a mutually exclusive break point, in my opinion. Hyperbole, you say. Panic, you say. Consider the following: The last $20 per barrel move in oil has added approximately $150 billion to the nation?s annual energy tab, an amount equal to the highly publicized and much anticipated US tax rebate. The problem is that instead of a new TV, it looks like that check is going to go 100% to the fuel bill. Worse, 50% of these funds leave the country to pay for oil imports, a complete economic drag. The velocity of money is significantly reduced via higher energy costs with very little resultant knock-on economic activity. Bottom-line, for the US consumer, higher energy costs can be zero-sum. Moreover, higher US natural gas prices could cost consumers another $50 billion this year and higher costs for oil, gas and coal WILL result in higher electricity prices over the next year, albeit with a delayed impact.
Note that oil prices are actually on track to average $40 per barrel higher in 2008 versus last year, thus costing consumers $300 billion y/y. Of course, these are all the observable ?direct? costs. Who knows how much the dramatic increases in energy costs results in higher ?indirect? inflation. The point is that there is likely to be much less consumer funds available, particularly for maintaining a household. The change in energy prices will most likely increase the rate of mortgage defaults, as certain homeowners are forced to throw in the towel. It will be interesting to see of the market can continue to rally as the energy impact becomes more pronounced?
The fed faces a significant choice next week. Either cut rates to assist mortgage holders, or fight the oil price increase by keeping firm on rates. Neither prospect is too appealing.
On to oil stocks: One of the purest plays on the higher oil price is Occidental Petroleum (OXY – $85), which this year should produce close to 470,000 barrels per day of high quality and even higher profit margin crude oil. Almost 80% of OXY?s output is oil, with the balance being mainly US natural gas production of 550 million cubic feet (mmcf/d). The company has zero refining (which is a good thing given current poor US margins) and a small chemical arm. At an average oil price of $105 per barrel this year and a gas price of $9, I calculate that OXY could earn $8.50 per share, up a solid 62% from clean, operating earnings of $5.25 per share in 2007. Thus, the stock is now trading at a P/E of 10x 2008 projected EPS. Cash flow could grow an impressive 45% to $11.75 per share versus $8.10 in 2007. Wow! More importantly, I project free cash flow could be over $6 billion this year, or over $7 per share in FCF. Double Wow!. That is after spending $4 billion on growing the business. With only 7% debt-cap, that is a lot of FCF for dividend hikes and stock buybacks (OXY has doubled the dividend over the last five years).
OXY is different from most E&P companies because it has lower capital requirements, which results in much higher FCF, and long life reserves. Reserve life for US oil, which is 75% of total oil reserves, is almost 18 years, which is practically unheard of in the industry. Obviously, if a company runs out of reserves, its earnings and cash flow should be valued less. OXY has long life, which is critical, in my opinion.
OXY is scheduled to report on Wednesday April 24. Consensus is at $1.95. I think they can do closer to $2.00 per share for 1q08. It does not really matter. These are not tech stocks where every penny counts. The point for OXY is that EPS could be up 110% y/y. That is why these stocks are working ? the growth in earnings and cash flow is huge. Moreover, EPS are almost certain to be higher in 2q08 given that the oil price averaged only $97 per barrel in 1q08. As we know, it is up another 20% since then. Look, everyone has their favorite exploration and production stock. APA, CHK DVN, EOG are all great names. My point is that they are already up 30% – 50% this year alone. OXY is up only 10% year-to-date, yet OXY almost has more free cash flow than the other names combined (almost, not quite, but the point is the same).
DISCLAIMER: OXY is an interesting idea, not a recommendation. I own the shares, but I know that if the price of oil collapses, so too will OXY?s stock price. Also, ideas may be worth exactly what one paid for them.
