ENERGY STOCKS A GOOD BET FOR 2004 AND BEYOND
There are two reasons to consider adding energy stocks
to your portfolio this year and keeping them for the long-term. The
global increase in demand, combined with the inevitable depletion of
supply, will likely continue to drive up energy stock prices. Some of
the most successful, best run energy companies also pay sizable dividends.
With interest rates and bond yields so low, an energy stock with a 3%
yield can also be a good income investment.
Linda Stewart for www.fizone.com
March 19, 2004
OUTLOOK FOR SUPPLY AND DEMAND
The prices of gasoline and crude oil have reached new highs, and the
prices of most energy stocks are approaching their 52-week highs. Normally
this would be a bad time to buy these companies, but there are plenty
of reasons to think energy prices will go higher. Consider the following
supply and demand data compiled in Barron’s 3/15/04 issue:
Supply:
- Oil (and natural gas) inventories are at historically low levels.
- World oil discoveries peaked in 1964.
- The average oil field’s output declines by 4.8% a year.1
- U.S. oil production, excluding Alaska, has declined to 4.8 million
barrels a day.
- OPEC produces more than a third of the world’s oil; OPEC maintains
quotas.
- OPEC holds more than half of the world’s proved oil reserves:
geopolitical risk.
- Newer technology depletes the oil more quickly.
- There is disagreement about whether or not oil production has peaked.
More than one [non-government] industry expert believes we are already
at or within five years of peak oil production. The U.S. Geological
Survey and the U.S. Energy Information Administration believe oil
production can continue to increase for 30 or more years.
Demand:
- Demand rises at about 1.5% annually, while output declines three
times as fast.1
- U.S. oil imports have increased to nine million barrels a day.
- Demand from emerging countries has increased. China's has more than doubled in the last 12 years.
DESPITE RECENT PRICE INCREASES, NOT ALL ENERGY STOCKS
ARE OVERVALUED
Energy stocks as a group were up more than 5% in the first two months
of this year. Still, proposed cuts by OPEC—they meet March 31
to decide—and growing demand out of China and other emerging
market countries should keep driving prices, particularly since this
group is not overvalued on a price to earnings basis. Compare the
industry averages for the energy subsectors to the S&P 500 Index
P/E of about 22.5.
P/Es for the energy group2:
- under 13: industry average P/E for the huge
integrated oil companies, averaging about $100 billion in market
cap
- less than 16: industry average P/E for the oil
and gas operations companies (exploration and production) that are
over $5 billion in market cap
- almost 50: industry average P/E for oil well
services companies (the “drillers”)
- under 16: industry average P/E for natural gas
companies over $5 billion in market cap
P/E isn’t the only means for judging valuation; nor is it necessarily
the best. I find the price to sales (P/S) ratio a better indicator of
value, as earnings per share is more easily manipulated to distort the
actual earnings, and it becomes problematical with negative earnings.
Sales per share is more straightforward, allowing companies’ businesses
to be easily compared. Using the P/S ratio, the energy group appears
less undervalued, but some stocks still qualify as reasonably priced.
The S&P 500 Index P/S is currently about 1.5, a reasonable valuation
to use as a guideline.
P/S averages2
are:
- 0.97: Integrated Oils
- 2.44: Oil & Gas Operations
- 2.76: Oil Well Services
- 1.72: Natural Gas
THE
BEST OPPORTUNITIES IN THE ENERGY SECTOR
The energy subsectors have many differences in pricing cycles and valuation
criteria, but they have in common this basic premise: If demand continues
to increase and supply is finite and being depleted, their products
and services will become more valuable. I don’t think there is
any doubt that this is the current situation for the supply/demand scenario.
Where is the best opportunity for investing in energy? I have considered
stocks from these four energy sectors, some obviously more income plays
than growth plays:
Integrated Oils — These behemoths do it all:
exploration, development, production, transport, marketing, and more.
They typically pay the biggest dividends, but, because their
size limits the amount they can grow, they are awarded the smallest
P/Es of the group.
Oil and Gas Operations (E & P) — These second-
and third-tier firms focus more on the exploration and production of
oil and gas, are typically mid-caps with some room to grow, and pay
smaller dividends.
Oil Well Services & Equipment — These drillers
function on a different chronological cycle (typically January through
May is when their stock prices peak), called into service when reserves
are being depleted. These stocks’ prices have been on a tear recently,
with shortages and political fears adding to their rise from the usual
post-winter depletion cycle. Their P/Es are currently very high, but
their earnings are expected to increase much more in the next year than
the other oil stocks. They usually pay little or no dividends.
Natural Gas — These utility companies typically
transport, store, and distribute natural gas through their own pipelines.
Once a customer is hooked up to their pipelines, they are unlikely to
switch. Natural gas also has the advantage of being the clean-burning
fuel. These companies’ dividend payouts vary.
ENERGY STOCKS AS INCOME INVESTMENTS
Before discussing the individual companies that I recommend from each
subsector, a sampling of current yields from the more traditional
income investment options follows. You can compare the dividend yields
of my energy stock picks to what is otherwise available:
| |
Current3
Yield |
Description |
| |
|
|
| |
|
Corporate Bonds |
| |
2.388 |
3-year A+-rated |
| |
|
|
| |
|
High Yield Bonds |
| |
3.215 |
3-year BBB+-rated |
| |
|
|
| |
|
Municipal Bonds (tax-exempt income) |
| |
1.348 |
3-year AAA California |
| |
|
|
| |
|
Treasuries |
| |
1.865 |
3-year Zero Coupons/Strips |
| |
2.80 |
5-year bond |
| |
1.57 |
2-year bond |
| |
|
|
| |
|
CDs |
| |
1.55 |
1-year CD |
| |
2.05 |
2-year CD |
It should be noted here that the above yields are
dependent on holding the bond, treasury, or CD until it matures. At
maturity you are paid the par or full value of the security you purchased;
the yield is determined by the difference between what you paid for
it and par. If sold before maturity, your sale price will probably
be less than par, thereby reducing the yield. With CDs there is also
often a fee for selling early.
The dividend yield of a stock is the result of a formula dividing
the dividend per share the stock pays by its price per share. If the
stock price goes up, and the dividend remains the same, the dividend
yield diminishes, but you can sell the stock for more. The dollar
amount of the dividend continues to be the same rate per share times
the number of shares you own. Dividends are usually paid quarterly.
MY ENERGY STOCK PICKS
Based on the depleting supply and increased demand, I believe energy
stocks should continue to do well this year and beyond. I have researched
many stocks in each energy subsector to come up with the following recommendations,
chosen because they meet my GARP (growth at a reasonable price) criteria
and/or offer income that competes with the fixed income market as quoted
in the previous section.
While some of these stocks are more growth-oriented, and others more
income-oriented, I believe they should all steadily appreciate in value
over the next few years.
Integrated Oils
BP plc (BP $50.084)
– BP pays $1.80 annual dividend, a yield of 3.67%5.
Its P/E is 14. Their revenues have increased every year for the last
five years. Their debt to equity and price to sales are appealingly
low (.2 and .8). On a total return basis the company has performed in
line with the S&P 500 over the past 15 years. Standard & Poor’s
expects earnings to increase about 13% in 2004, free cash flow to remain
solid, and the company to buy back $5 billion of its stock this year.
Their 12-month target price is $53, and they have a Hold rating on the
stock.
ChevronTexaco (CVX $88.20) – Chevron pays $2.92
annual dividend, a yield of 3.32%. Its P/E is 12. They have raised their
dividend 16 years in a row. The company is reorganizing to raise returns
and they are selling non-core assets. Their debt to equity is a reasonable
30%, as is the P/S at .8. Last year the company outperformed its peers,
in line with the S&P 500 Index. S&P has a 12-month target price
of $84, and they rate the stock a “Hold”.
Oil & Gas Operations/Exploration & Production
Companies
Anadarko Petroleum (APC $52.61) – Anadarko’s
annual dividend is $0.56, a yield of 1.1%. Its P/E is quite low at 10,
suggesting the stock price has room to move up. Exploration and production
accounted for 95% of 2002 sales. The company believes 4% to 10% production
growth is likely in 2004. S&P has a 12-month target price of $52
and rates the stock a “Hold”.
Pioneer Natural Resources (PXD $33.17) – Pioneer
pays an annual $0.40 dividend, a 1.21% yield. They also have a low 10
P/E, but their 5-year growth outlook is 14%, higher than Anardarko’s.
This company expects production growth of 15% - 25% for 2004, and about
10% for 2004 – 2008. They plan to use excess cash to pay down
debt and to buy back up to $2 million in shares. S&P has a 12-month
target price of $38 and rates the stock “Accumulate”.
Oil Well Services/Drilling
Nabors (NBR $45.30) – The world’s largest
oil and gas land drilling contractor pays no dividend. They have a rather
high P/E at 35, but their 5-year growth rate is estimated at a robust
21%. 2005’s earnings per share are estimated to increase by 29%.
S&P expects total U.S. land drilling activity to strengthen, and
Nabors to benefit offshore as well due to three new platforms being
deployed in 2004. Their 12-month target price is $53, and they rate
the stock a “Buy”. (This company has been on my Growth Stock
Recommendation List since December 2003.)
Patterson UTI (PTEN $35.77) – This U.S. land
drilling company pays no dividend and has a high P/E of 51, but it has
no debt, has a 5-year growth estimate of 20%, and its earnings per share
are estimated to increase 44% in 2005 over 2004. S&P expects operating
income to more than double in 2004, and earnings and cash flow growth
to be significant. They have a 12-month price target of $42 and rate
the stock “Accumulate”.
Natural Gas
Kinder Morgan (KMI $64.30) – KMI pays an annual
dividend of $2.25, a yield of 3.69%. Its 20 P/E is reasonable, its 5-year
growth estimate of 13% is in line with the S&P 500 Index, and its
earnings are estimated to increase almost 11% in 2005 over 2004, which
S&P thinks will be 13% higher than 2003. Kinder Morgan is one of
the largest U.S. natural gas and oil storage and transportation companies,
operating 30,000 miles of gas and oil pipelines. It acts as general
partner to Kinder Morgan Energy Partners, a limited partnership whose
cash distributions account for about half of KMI’s earnings. S&P’s
12-month target price is $61, and they rate the company “Hold”.
USING EXCHANGE TRADED FUNDS6
TO BUY ENERGY COMPANIES
There are three exchange traded funds (ETFs) that
are comprised of energy companies:
- Select Sector SPDRs (XLE)
- iShares Dow Jones U.S. Energy (IYE)
- iShares S&P Global Energy Sector (IXC)
An ETF is a basket of companies, in this
case all energy stocks, that can be purchased like an individual stock,
including paying a commission when buying and selling. An ETF, which
follows an index, is more cost efficient than a managed mutual fund
in which the holdings change, incurring transaction costs. It is a good
way to "own a sector" without having to choose the best stock.
These three ETFs have in common an overweighting of Integrated Oil companies,
the Global iShares comprised entirely of integrated oils. The first
two have 40% and 51% respectively in the same three holdings, although
not in the same order: Exxon Mobil, ChevronTexaco, and ConocoPhillips.
Their next largest group (as a percentage of total holdings) is the
Exploration & Production companies. The biggest distinction, in my opinion,
is that the SPDRs ("spiders") ETF has a lower expense ratio (.28% vs.
.60% for the iShares), making it more attractive.
Income from an ETF is paid out as a distribution. XLE and IYE pay quarterly,
and IXC pays annually (in January). For the last 12 months or for 2003
their distributions per share were:
| |
XLE - $0.484
= 1.6% yield |
IYE - $0.73
= 1.4% |
IXC - $0.6187
= 1.0% |
Like the underlying companies, each ETF is currently near its 52-week
high.
CONCLUSION
If you believe, as I do, that our energy supply is finite and our demand
for it seems limitless, then energy stocks seem poised to benefit from
this scenario for quite some time. If you’re less convinced about
supply shortage, you still might want to consider investing in British
Petroleum, ChevronTexaco, or Kinder Morgan as an income-producing stock.
These stocks are bound to continue having up and down moves in their
stock prices, but I think over the long term the move will be upward.
If you decide to buy one or more of them, I would recommend waiting
for a dip since they are near their 52-week highs.
Choosing one of the ETFs is also a sensible way to gain exposure to
the energy sector. However, the yield is not compelling. For income
you would do better buying one of the integrated oil stocks.
123456
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