$50 Oil Forever?

Not quite. History and the markets cast doubt on government projections.

Rich Smith
Rich Smith
Dec 15, 2005 at 12:00AM
Other

On Monday, the mainstream press went ga-ga over a new report released by the Department of Energy. No, really.

You wouldn't ordinarily expect a government agency's technical document on pricing trends to attract immediate and high-profile coverage from the likes of BusinessWeek and The Washington Post. But this report was different.

It was about oil.

Specifically, it was about the Energy Department's Energy Information Administration (EIA) changing its mind -- in a big way -- about where the price of imported crude is headed over the next quarter-century.

Briefly stated, the story goes like this: One year ago, the EIA believed that over the next 25 years, the price of oil would decline over the next quarter-century until it finally bottomed out at around $31 per barrel by the year 2030. This week, the EIA apparently noticed a misplaced decimal, a switcheroo of liters for gallons, or some similar mistaken assumption, and changed its mind about that $31 endpoint. How much did it change its mind?

Oh, about 184% much.

$50 oil for the rest of your life
As of Monday, the official "party line" held by the U.S. government on the subject of oil pricing shifted from "$31 oil" to "$57 oil" in 2030, with prices hovering in the neighborhood of $50 a barrel between now and then.

This is essentially the picture that the EIA is painting: For those of you in your 50s and up, you can expect to live out the rest of your life without ever again seeing the return of "cheap oil." Anyone younger can forget about early retirement, because you're going to need the income to keep your car running.

So what are investors supposed to do, faced with news like that? Run out like lemmings to buy shares of ExxonMobil (NYSE:XOM) and hold on to them for dear life? (Lemmings, that is, who are conversant with the mechanics of equities trading, have active brokerage accounts above a $2,000 minimum, and earn dependable, high levels of disposable income.)


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That's precisely what a number of investors did earlier this week, inspired by the announcement that this year's record-breaking oil profits are here to stay. Since Monday, shares of ExxonMobil are up 2%. Total (NYSE:TOT) is up 3%; Eni SpA (NYSE:E), nearly 4%.

On the other hand, BP (NYSE:BP) and Chevron (NYSE:CVX) are both trading at about the same price their shares fetched last Friday, and ConocoPhillips (NYSE:COP) is actually down a bit -- albeit on news of its Burlington (NYSE:BR) bid.

So three of the world's biggest oil majors are up on the EIA's news. But that forces the question: Why isn't everybody up? Sure, the various oil companies each have their peculiarities; some are cheaper than others; some are more efficient, more profitable, and so on. But as a whole, each of these companies has hydrocarbon reserves, and if the long-term value of those reserves has just increased by 84%, then shouldn't each of the companies now increase in value by roughly the same amount?

They should, if .
If you believe the government knows what it's talking about. I don't. And I've got history and the stock market both on my side in this. I'll explain.

History first. Clearly, the fact that the EIA took such a drastic price-projection-U-turn based on, essentially, no new information, calls into question the reliability of its new estimates -- and its one-year-old estimates, and, really, all of its past and future estimates. What has happened over the past 12 months that could nearly double the value of the world's oil reserves? Running through the list of usual suspects, I can name several. China is booming. We had so many hurricanes that we needed to resort to the Greek alphabet to name them all. Terrorism rages in the Mideast. But what all of these factoids have in common is that none of them are new. China's been around for a long time, and it's been booming for years. Terrorism's been around for decades. Hurricanes, even longer.

Now I don't mean to fault the EIA for its work. I'm certain that its people work very hard trying to get things right. The problem, however, is that human beings have an ingrained tendency to look at the present and project it into the future. Few among us, seeing $70 oil not long ago, $60 oil today, and monthly doomsday calls for $100 oil being published by Goldman Sachs, aren't at least a little bit worried that prices will be high going forward.

But that tendency to stretch the "now" into the "forever after" works both ways. As recently as 1998, oil prices were at their lowest levels in nearly two decades, and the EIA was projecting $23-per-barrel oil by 2020. (In 2004 dollars, that would be $26). Yet China was doing fine. Terrorism and hurricanes were rolling along, too.

So to summarize: When oil prices are at historic lows, the EIA tends to project low prices into the future. When at historic highs, it predicts future highs. This doesn't mean the EIA is wrong, mind you. We'll have to wait until 2020 and 2030, respectively, to learn whether its estimates -- and which ones -- are correct. But it does mean that EIA projections should be taken with a grain of salt and other resources be drawn upon to inform an investment thesis.

Meet Mr. Market
One resource I like to use, for example, is a very wise old gent by the name of Mr. Market. Mr. Market's been around for quite some time, and he's quite familiar with the pricing ebbs and flows of cyclical industries such as Big Oil. Knowing that neither lucrative nor stingy profits last forever among these companies, he tends to discount both the highs and lows.

This is the source of the old market truism that when a cyclical company has a low P/E, it should be sold -- because profits are so massive that we're likely nearing a profitability crest. Conversely, when its P/E looks stratospheric, the reason is that its profits are so low they're bound to turn upward soon -- and that's the time to buy.

Take a look, then, at what Mr. Market tells us about the oil majors, in the form of their past P/E highs and lows, and where he's pricing them today. (And for reasons that will soon be apparent, let's look at their dividends, too):

Company Past Decades:
High P/E
Past Decades:
Low P/E
Current P/E Dividend

BP

48

10

12

3.2%

Chevron

86

7

9

3.1%

ConocoPhillips

59

5

7

2.0%

Eni

23

6

13

6.2%

ExxonMobil

39

10

11

2.0%

Total

36

8

13

2.8%

Current P/Es and dividend data provided by Yahoo! Finance. Historic P/E data provided by Standard & Poor's.

So for the most part, Mr. Market is pricing the oil majors within a point or two of their historic lows on a P/E basis. At the least, this suggests that, whatever the EIA's views, Mr. Market remains skeptical. At the most, it says that Mr. Market appears to be saying that the EIA is dead wrong and that the oil price cycle is about to crest.

If the latter case proves to be correct, you can be bet that the EIA will be there for you, to "forecast" the next pricing shift after it has happened.

So is there a way to earn dependable profits from investing in oil, whatever its point in the hydrocarbon pricing cycle? You bet -- it's called dividends. They're the bread and butter of the Fool's ownIncome Investor newsletter, and guess what? We've even named Total as a recommendation.

Learn what other dividend-rich stocks we like, just by trying the newsletter out for 30 days. Best of all, it won't cost you a dime to try. Just click here, and we'll give you a free trial -- and if you don't like it, you can cancel any time, no strings attached. You have our word on it.

Fool contributorRich Smithdoes not own shares of any company named above. If he did, The Motley Fool would require him to tell you so. We're sticklers about things like that.