On Friday, March 5, oil prices hit post-Iraq war highs. The OPEC oil cartel made a surprise decision on Feb. 10 to cut its total output by 2.5 million barrels per day, or almost 10%. Since that day, oil prices have surged more than $3 per barrel to over $37 per barrel.
The prospect of sustained high oil prices is likely to create some interesting opportunities for equity investors in the sector. It is traditionally a rather unexciting industry, with five-year revenue and EPS growth rates significantly lagging those of the Standard & Poor's 500 index, and the P/E ratio of the industry is less than half the P/E ratio of the S&P 500. However, the oil industry does have a handful of stocks that are worth considering, particularly when external factors such as OPEC's recent decision create strong tailwinds for oil stocks.
Oil prices
Most analysts were surprised by OPEC's decision to cut output. A few days before the meeting, Bank of America (NYSE:BAC) said that it was "90% likely" that OPEC would hold to its quota of 24.5 million barrels per day. Prior to the decision, oil had been trading close to five-year highs, at around $30 to $35 per barrel (for West Texas Intermediate or WTI crude). At these levels, oil was well above OPEC's target price range of $22 to $28 per barrel.
Analysts have suggested a number of reasons why OPEC decided to cut oil production and shore up oil prices. One reason may be the increasing oil production from Russia (not an OPEC member), which makes it harder for the Saudis to manage prices. Another factor may have been the perceived instability of demand for oil from China, which in recent months passed Japan to become the world's second-largest importer of oil (after the U.S.). OPEC could well have been concerned about an impending drop-off in demand from China, and tried to act proactively on Feb. 10.
Even before the announced cut in output, most industry analysts were calling for continued high oil prices. Demand for oil in the U.S. is picking up as the economy is recovering, and the current administration -- with close ties to the industry -- routinely opposes proposals to raise mileage requirements or tighten other energy standards.
Oil-consuming nations have expressed concern about rising oil prices. The International Energy Agency, representing 26 industrialized nations, recently stated, "OPEC should take into account that the market is not well supplied. Oil prices are too high. It's bad for the economy, bad for consuming countries, and not very good for producing countries either." In addition, the Economist magazine has questioned the ability of OPEC members to stick to their new quotas -- cheating has long been a problem for the cartel.
Despite these pressures on oil prices, the recent cut in OPEC production strongly increases the likelihood that oil prices will remain elevated for a considerable period of time. If that proves to be the case, the oil industry should see significantly increased profits.
Investment opportunities
Despite the recent increases in oil prices and indications of continued high prices, industry valuations remain significantly below broader market valuations. According to Multex, the industry P/E is 12.9 compared to 25.3 for the S&P 500.
Prior to the OPEC announcement, Bank of America highlighted three stocks as undervalued. The "buy" recommendations include industry leaders ExxonMobil (NYSE:XOM) and BP (NYSE:BP), as well as a lesser-known company, Suncor (NYSE:SU).
ExxonMobil and BP are large, stable companies with $247 billion and $233 billion in revenues, respectively. Both stocks have reasonable valuations metrics. ExxonMobil stock trades at a forward P/E of 19 and an enterprise value-to-EBITDA of 7.5. BP's valuation metrics are in the same ballpark, with a P/E of 16 and an EV-to-EBITDA ratio of 7.2. In an environment of higher oil prices, both stocks merit consideration, especially for income-oriented investors. BP has a dividend yield of 3.7% and ExxonMobil has a yield of 2.4%. (If you're looking for other higher-yield investments, check out our Motley Fool Income Investor newsletter.)
But the real investment opportunity in this industry may be Suncor. It is still a relatively small company ($4.4 billion in revenues), and boasts an impressive track record of growth and consistently high profit margins. Over the last five years, it has grown revenue 18% per year, and EPS 23% per year.
Its core business model is based on mining oil sands in Alberta, Canada. Oil sands are deposits of bitumen, a heavy, black, viscous oil that must be rigorously treated to convert it into an upgraded crude oil before it can be used by refineries to produce gasoline and diesel fuels.
Oil sands are found in two places in the world: Alberta and Venezuela. According to the government of Alberta, oil sands production currently represents one-third of the oil produced in Canada. By 2005, oil sands production is expected to represent 50% of Canada's total crude oil output, and 10% of North American production.
Sunco is one of only two major companies that produce oil from Alberta's oil sands. The other is Syncrude, a privately held joint venture of eight Canada-based oil companies. Both Sunco and Syncrude produce about 200,000 to 250,000 barrels per day (bpd).
The business model is highly profitable. Over the last five years, Suncor has an average operating margin of 16% and a net profit margin of 10.5%. While highly capital-intensive, management estimates that with oil prices at $22 per barrel, it can maintain a 15% return on capital employed (ROCE). Higher oil prices significantly increase profitability. In the last year, operating profits were 29% and net margin jumped to 17.5%.
Eighty percent of the oil sands in Alberta have yet to be developed, and Suncor estimates that it can more than double production to over 500,000 bpd in the next six to eight years.
As oil prices remain high, Suncor has been using the excess cash it is generating to pay down debt, and the company exceeded its target of paying down C$700 million in 2002 and 2003. "Aggressively paying down debt while commodity prices are high puts Suncor in a stronger position for any downturn in the crude price cycle," commented CEO Rick George in the company's latest earnings release. The company's debt-to-equity ratio stands at 0.6.
Despite the company's impressive track record of profitable growth, valuations remain modest. Suncor stock is trading at a forward P/E of 15 and an enterprise value-to-EBITDA ratio of 7.7, in line with industry giants ExxonMobil and BP.
The prospect of continued high oil prices combined with Suncor's solid fundamentals make the stock look quite attractive at current valuations. In a traditionally slow-moving, low-growth industry, this stock has exciting upside potential.
Motley Fool contributor Salim Haji does not own shares in any of the companies mentioned. For him, higher oil prices result only in the fact that he pays more at the pump. The Motley Fool is investors writing for investors.
