Jim Jubak

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Posted 6/15/2005

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Jubak's Journal
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 Jubak's Journal
5 stocks for the continuing oil rally

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The price of oil remains at steep levels. The best way to play it is to find companies where sustained high prices will make costly new exploration and production pay off big.

By Jim Jubak

Has there ever been a more irrelevant OPEC meeting than this week's?

Oil ministers from the Organization of Petroleum Exporting Countries would love to increase supply, but they can't since the cartel is already pumping just about all the oil it can and production is well above the official ceiling.

Crude oil production isn't at the heart of the current problem anyway. Instead, the world is faced with a shortage of the kind of sweet grades of crude that oil refiners prefer and OPEC can't pump at the margin, and with a worldwide shortage of oil refining capacity. Globally, refiners are operating at 95% of capacity, compared to run-rates near 75% of capacity in the mid-1980s.

And the numbers that the OPEC meeting is most likely to move, the much-watched benchmark prices for oil, are the least important numbers to watch now anyway. Yes, the benchmark price for light, sweet crude futures for July closed at $55.50 a barrel Tuesday on the New York Mercantile Exchange, just slightly below Monday's close, which had been the highest closing price since April.

The important action is in other numbers now. I'm watching two in particular.

The key figures
First, there's the discount from its own benchmark price that OPEC gives to oil refiners. Back in October 2004, OPEC was offering oil traders and refiners a $14.20 a barrel discount for its benchmark Dubai crude. So even though the quoted market price for a barrel of light sweet crude oil was $51, the real cost to a U.S. oil refiner last October for a barrel of OPEC's heavier oil was $37.

In the months since then, that discount has gotten narrower until it's now just $2. So a U.S. refiner buying OPEC oil isn't paying $37 when the market benchmark is $51 but $50 a barrel when the market benchmark is $52.
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That amounts to a huge price increase in the only kind of oil that's available to meet demand at the moment. And it's a sign that despite all its talk about being worried about high oil prices and the possibility that they might slow the global economy (and reduce demand for oil), OPEC is quite comfortable with oil prices above $50 a barrel. In fact, you might conclude that the cartel will do all it can to keep them at these levels until it sees real evidence of falling economic growth and lower demand for oil.

The second number I'm watching comes from the oil companies. The major oil companies are notoriously conservative in their forecasts of the price of oil and they use those projections in setting their exploration and production budgets. In spite of the huge run up in oil prices, oil companies have kept to projections in the upper $20s per barrel. That's one reason that oil exploration and drilling activity have been slow to pick up despite oil prices north of $50 a barrel.

Straying from the pack
On June 8, BP (BP, news, msgs) broke ranks. In comments in the House of Lords, BP CEO John Brown said that world oil prices were likely to remain above $40 a barrel until new supplies come on stream in three to four years. His figure is about two times the benchmark that BP has been using in its own internal planning for capital spending. And it's roughly $10 a barrel above the $30 figure that BP and other big oil companies have fingered as the support level for oil. The important thing here isn't whether Brown is right, but that BP and other oil companies are planning for a world of higher oil prices.

My conclusions for investors after putting these two numbers together: The oil stock rally still has more legs, and the best way to play it is to find companies where sustained high oil prices will make costly new exploration and production pay off big. Oil producers that are developing new supplies in areas where the risk and costs of production might have been daunting in a world of $30 oil are likely to be the big winners in a world where oil stays above $40 a barrel and quite probably above $50 a barrel.

I picked three stocks that fill this bill during my regular appearance on CNBC's "Morning Call."

The Libyan connection
  • Occidental Petroleum (OXY, news, msgs) was the big winner when Libya reentered the global oil market. Occidental, which had produced oil in the country for decades before sanctions were imposed, won the right to explore and produce oil on five of the 15 blocks let out for bid. Libya has proven resources of 40 billion barrels of oil, which puts it eighth in the list of global oil producers. So it's extremely likely that Occidental's exploration will pay off. Even better, Libya produces light, low-sulfur oil, a precious commodity now because just about all the extra production promised by OPEC will be harder-to-refine heavy oil.

    This year Occidental should be able to increase production by about 3% over 2004, and that's before the company sees any oil from Libya. After reducing debt by $665 million in 2004, the company will see a $65 million reduction in interest expenses this year. Analysts call for the company to earn $6.96 a share in 2005. That'll turn out to be low by almost $1 a share. Add that surprise to the growing value of the production coming from Libya and you have a recipe for further stock gains. The shares also carry a 1.6% dividend yield. Our StockScouter rated the stock a 10 out of a possible 10 on June 15.

    Bouncing back
  • Suncor (SU, news, msgs) had a truly terrible first quarter. A fire at its oil sands project cut production and squashed earnings: The company reported 21 cents (Canadian) for the quarter when Wall Street expected 37 cents (Canadian), and the stock plunged almost 15% in April's first two weeks.

    But the stock has recovered as the company continues to make progress on its first major production expansion since 2002. The key for Suncor is the company's huge deposits of oil sands: The company estimates that its Athabasca sands hold a potential 11 billion barrels of oil. The price of oil dictates whether it makes sense to turn oil sands into oil. Below $25 the process isn't especially profitable. Above $30 the company really starts to earn money as the price leverage kicks in. And that's even with the rising cost of natural gas, which is used to heat the oil sands so they'll release oil. Even better, Suncor has its own deposits of natural gas, and the company believes it can reach self-sufficiency in natural gas.

    Suncor should be back to full production of 225 thousand barrels a day by September, and the company projects that it can increase production to 260 thousand barrels a day by the end of the year. A major expansion, expected to cost $5.9 billion (Canadian) will take production up to 550 thousand barrels a day, better than doubling current production, by 2011 to 2013. Our StockScouter rated the stock a 9 on June 15.

    Risk with reward
  • Imperial Oil (IMO, news, msgs) is for investors who'd like exposure to the high-risk, high-reward potential of Canada's oil sands, but would like it wrapped up in a conservative financial package.

    Imperial Oil accounted for almost 20% of Canada's oil from oil sands production in 2004, and the company holds the lease on 460,000 acres of Alberta oil sands. That's a lot of potential oil production, if oil prices stay high, if oil sands processes scale efficiently and if higher natural gas prices don't wipe out profits. Balancing that risk is one of the oil industry's most productive cash flow machines. In 2004, Imperial Oil produced free cash flow of $1.3 billion, and that's after investing $1.1 billion in property, plants and equipment, after spending $700 million on stock buybacks, and after dishing out $264 million in dividends. The stock carries a dividend of 1.2%. About 70% of outstanding shares are owned by Exxon Mobil (XOM, news, msgs). Our StockScouter rated the stock a 10 on June 15.

    Exclusive picks
    And, as always, here are two more exclusive picks for CNBC.com on MSN readers.

  • Encana (ECA, news, msgs) has been steadily increasing its risk profile by selling its older conventional oil and natural gas holdings and putting the money to work in riskier projects. Well, at least they'd be riskier for another company.

    Encana has built a reservoir of expertise in tapping unconventional natural gas deposits that enable it to sell easy-to-access deposits to other energy companies at high prices and then use those funds to buy gas reserves that sell at cheap prices because most companies don't have the technology to tap into them. (In addition, Encana has sold some of its mature holdings in Western Canada at good prices because of the demand for fields with proven cash flows from Canada's energy trusts.) All this repositioning has left the company with a stronger balance sheet and a cash balance at year end of $602 million. It also has a collection of very high-grade fields that Encana has proven it has the technology to tap. Our StockScouter rated the stock a 9 on June 15.

  • Transocean (RIG, news, msgs) is my favorite play on oil drilling rather than oil production. (I added the stock to my online portfolio Jubak's Picks on April 26.)

    With Transocean, investors get a driller leveraged to the deepest of deepwater projects, and that's where the growth is in exploration and production in the Gulf of Mexico these days. With few drillers adding new deepwater rigs, which would take a long time to get to market anyway since they take so long to build, Transocean can look forward to increased day rates well into 2006. In fact, the deepwater rig market is showing shortages in some production areas, such as the North Sea. With deep water rigs just about booked to capacity, oil production companies have started to push up utilization and day rates for mid-water rigs, too.

    Wall Street analysts have started to boost their earnings estimates to $1.64 a share for 2005, up from $1.46 90 days ago, and to $3.44 for 2006, up from $2.51. But Wall Street is still underestimating how far oil prices of $50 or better a barrel will push up day rates for drilling rigs and how long that run will last.     Our StockScouter rated the stock a 10 on June 15.


    Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.

    E-mail Jim Jubak at jjmail@microsoft.com.

    At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Encana and Transocean. He doesn't own short positions in any stock mentioned in this column.

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