Jubak's Journal
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10 winners for the next oil rally
Don't let falling oil prices fool you. The long-term trends for oil and gas are still in place. But the winners in the next run-up will be smarter and nimbler.
By Jim Jubak
The rally in oil and gas stocks is dead. Long live the rally in oil and gas stocks.
No doubt about it, the profit-taking in the sector that began as soon as the third quarter ended has taken a bite out of energy stocks. The Amex Oil Index ($XOI.X) fell more than 10% from Sept. 30 through Oct. 14. And with the price of oil in its own 11% correction, it's not certain that the damage to oil and gas stocks is over.
Oil stocks jumped 124% in the two years beginning on Sept. 30, 2003, and the longer-term trends that fueled that rally are still in place. The current sell-off is a pause, and I think investors can expect the long-term rally to resume as soon as some of the speculative excesses of this past run-up are worked off. And it should last possibly through the end of the decade..
The next stage of the rally, however, won't be like what's just concluded. To this point, oil and gas prices have risen so far and so fast that all oil and gas stocks have gone up. Even investors who plunked down their money on mediocre energy companies did well. In the next stage of the rally, however, stock picking will be more important, and the biggest gains will go to investors who pick the best oil and gas companies.
In this column, I'll explain why I think the energy rally will resume, describe how the next stage will be different and select the 10 energy stocks that should, in my opinion, perform best.
Demand outruns new production
My logic is pretty simple: Energy prices are likely to continue upward for the rest of the decade.
Oil production is projected to grow by an annual 2% a year through the end of the decade -- if you believe that oil companies will actually be able to complete planned production projects on schedule. I dont buy it. New oil production is coming from deeper water, from less stable countries and from more complex geologies than was the case 10 years ago. This is resulting in serious delays in bringing planned production to market. Because of delays, oil production in 2007 will be 2 million barrels a day less than planned by oil companies, Bernstein Research has calculated. That kind of slippage suggests that oil production will grow by something close to 1% annually -- not 2%.
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Forecasts for world oil-demand growth for next year range from 2% (from the International Energy Agency) to 2.3% (from the U.S. Department of Energy, which now projects that crude oil will stay above $63 a barrel in 2006.) The projected average annual demand growth to the end of the decade: 1.8%
If the pessimists are right about production growth, the world is looking at tighter oil supplies through the end of the decade. Even if the optimists are right, the margin between supply and demand will remain small enough to produce a steady stream of energy crises that keep pushing prices up.
But it's not just short supply and growing demand that will keep energy prices moving up. Much of the new supply will be more expensive to produce and more expensive to refine. Producing oil from oil sands, for example, breaks even somewhere near $30 a barrel.
And much of the oil from these new sources, as well as new production from sources such as Saudi Arabia, consists of heavy sour grades of crude (crudes with high sulfur content) that are expensive to refine -- if you can find refinery capacity for these grades at all. Sour crude contains more than 1% total sulfur content.
Marathon Oil (MRO, news, msgs), for example, recently reported that that the average spread between the price of sour crude and light sweet crude widened from $7.77 per barrel a year ago to $9.52 a barrel.
But refinery capacity isn't just a bottleneck for heavy grades. Because the global refinery industry is operating at full capacity, refiners can charge more to refine petroleum products. For Marathon, the Chicago crack spread -- the difference between the price of a barrel of crude at the refinery and the value of the products produced from that barrel and sold in the Midwest -- reached $17.29 a barrel in the third quarter of 2005, up 124.5% from $7.70 a year ago.
Time to get selective
So if the price trends are all still up, why should the next stage of the rally be less spectacular and more selective?
While the price of oil climbed 52% through the first nine months of 2005, the price may jump only 20% in 2006. Refinery crack spreads at the end of September were nine times the 20-year average. Refiners won't see run-ups like that in 2006, and there's a good chance that crack spreads will come down from current highs as U.S. refineries get back on line after the Gulf hurricanes. Meanwhile, costs for everything from steel pipe to drilling rigs are climbing. In some cases, costs for oil companies are climbing faster than the price of oil. That will moderate stock gains in the sector.
These trends will separate the great companies from the mediocre ones. Companies that don't control costs well will see margins fall. Refiners with capacity in the sour end of the oil-grade spectrum will see bigger margins than their peers. Oil producers with a history of adding reserves at low cost will outpace peers who struggle to find oil or overpay for reserves. And pick-and-shovel makers -- maybe, since this is oil, we should call them drill-and-pump makers -- could well outperform even the best producers.
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