Choosing the Best Oil Stock
Oil surely had a though year.I compared the 1 year stock performance of some of the biggest oil companies: Petroleo Brasileiro Petrobras (NYSE: PBR) , Royal Dutch Shell (NYSE: RDS-A) , Statoil (NYSE: STO) , PetroChina Company (NYSE: PTR) and Cenovus Energy . All of these stocks delivered negative returns, reflecting the fact that crude oil's risk premium (the minimum amount investors are willing to accept for compensation of owning a risky asset) has declined significantly from the high levels of February and March last year (at the height of Iran tensions).
However, the picture looks quite different if we look only at the past 30 days market performance. With Petrobras and PetroChina leading the way, aboslutely all of these oil stocks delivered positive returns bigger than 1%. Is this an early sign of recovery?
The Macroeconomics of oil
Investing in oil is certainly not for the faint hearted. Due to its high price volatility, oil should be seen as a trading investment. However, some companies may be more exposed to oil volatility than others. In the next section, I will discuss how each major oil player is positioned at the moment. For the moment, I introduce some macroeconomic reasons to be an oil bull.
First, supply shocks seem to be tightening the supply-demand balance, representing an upside for oil price. Since early June, crude oil inventories have been declining. Crude oil inventories usually decline by this time of the year, but not this much. The fact that institutions like the Department of Energy have now relatively less barrels of inventory is a bullish sign, as either a weaker supply or greater demand would push the price up.
In the long run, we are seeing more signals of a global macroeconomic recovery which is likely to increase demand. Chinese growth rates remain high as the country tries to stimulate national consumption and shift the economy from an export-driven to a consumption-based focus.
Finally, according to the IEA Oil Market Report, oil demand is expected to surge from the first to the last quarter of the year by 1.9 million bdp. Since the OECD supply is projected to increase only slightly (from 20.6 million bpd in the first quarter to 21.0 million bpd in the last quarter), there could be a slight demand imbalance in the making, around 1.5 million bdp. This gap will need to be filled by the OPEC or by using existing inventories. Both possible outcomes are bullish signals.
Horizon: 3 months
Oil stock picks
Now that we have showed why simple laws of supply and demand suggest a mild increase in oil price for the next 3 months, let us choose a strong oil company that could benefit the most from the macroeconomic improvement.
Let's start with one of the biggest, Brazil's Petrobras. As the second largest energy company in South America in terms of market capitalization ($92 billion) and with a current share price will below its 52-weeks high ($14.5 current, $24.83 highest), the company does provide value to investors. Unfortunately, the fact that Petrobras relies entirely on Brazilian production adds significant geopolitical risks due to government policies, change of political regime in the long run, royalties and variable taxes. Add to this the fact that it is relatively expensive to develop oil infrastructure in Brazil due to the water depth, and you have a high risk, high-reward oil stock.
Petrobras is quite huge in South America, but still small if compared with giant Royal Dutch Shell .The company recently reported disappointing second quarter earnings, missing the street consensus and causing a 5.7% drop in price on the day of the announcement. Is this a buying opportunity? At the moment, the company is still far from reaching its 2012-2015 Plan (which involves improving operating cash flows between 30 and 50% versus the previous four-year period, and capital investments of $120 to $130 billion over the period). Shell's $24 billion of cash generated during the first 6 months of the year is actually $2.7 billion less than 2012 over the same period. So far the company has only delivered $70 billion out of its $175-$200 billion target for the period. Keep also in mind that increasing costs for replacing reserves and low prices of natural gas in North America could make the task even more challenging. I believe that with effort, Shell can reach its lowest prediction, but the $200 billion upper limit seems difficult.
Source: Shell Investor Relations, Presentation Slides
With a current $68 billion market value, Norway's biggest oil & gas group, Statoil , is small and relatively cheap. The company has intentions to keep growing its already attractive dividend. However, due to increasing capital expenditures (currently around $19 billion), the company's free cash flow is actually negative after dividends. A come-back to positive free cash flow is expected by 2016, according to official predictions. If this does happen or, even better, happens sooner, Statoil could benefit from a more realistic valuation.
Finally, we have PetroChina Company , a huge corporation at the heart of the most attractive emerging economy in the world, with reserves of 22.3 billion barrels of oil. The company looks pretty secure as the largest oil and gas company in a nation hungry for oil. Notice that the stock price has declined 17% since early 2013, which make shares even cheaper.This is probably due to the short-run effect on profitability that the decrease in the price of gas by 310 RMB a ton had. However, when looking at the long-run picture, I see plenty of upsides. First, the fast that PetroChina has safe domestic demand in the second biggest economy of the world is attractive. Then, PetroChina has the ability to access resources in other countries, and this could add more diversification to revenue sources in the long run. Finally, as China shifts from an export-driven to consumption-driven economy, the demand for cars and gasoline is set to rise, adding further cash-flow generation.With its numerous investments in Europe, Canada, Iraq and Australia, the future for PetroChina looks quite promising. Diversification, safe & strong domestic demand, abundant reserves and high exposure to emerging economies makes PetroChina my best pick for an oil stock.
View: Very Bullish