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Forbes
3 ways to pick the best oil stocks
Oil prices are up. How do you capitalize on that fact? Oil reserve expert Nick Cacchione says good buys are out there -- in unexpected places.
By John Turrettini, Forbes
For all the howling from drivers about gas prices lately, Wall Street is not particularly enamored of oil. Industry kingpin Exxon Mobil trades for 13 times trailing earnings, about half the market multiple. The presumption is that the price of oil, now $35 a barrel, will collapse and take Exxon's profits with it. The April 2005 futures price on the New York Mercantile Exchange is $30.58.
But Nicholas Cacchione disagrees. The codirector of research at venerable oil-research firm John S. Herold forecasts that energy prices will stay strong in the near term. He predicts that the Organization of Petroleum Exporting Countries will succeed with its scheme to cut production by a million barrels a day. That, with further worldwide economic recovery pushing up demand, will keep prices buoyant.
Cacchione has a system for picking oil stocks, and it has nothing to do with price/earnings ratios. He rates companies largely on the basis of what their reserves are worth.
This is a risky business, especially if you can't trust the reserve figures. Both Royal Dutch/Shell (RD, news, msgs) and El Paso Energy (EP, news, msgs) recently admitted to overstating them; the Securities & Exchange Commission doesn't even demand that they be audited. But income figures, which are audited, are scarcely proof against error, and you have to judge stocks on some basis. Cacchione turns the published reserve figures into forecasts of cash flow over the next 15 years, then discounts that putative income stream into today's dollars and arrives at a liquidation value of the oil in the ground. He tends to like stocks trading at or below their reserve values.
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Pickings are slim
Of the 125 companies that he and nine other analysts at Herold's Norwalk, Conn. offices survey, Cacchione recommends only a handful to the company's clients. The list doesn't include familiar names like Exxon Mobil (XOM, news, msgs) and ChevronTexaco (CVX, news, msgs). Reason: These trade at prices well above Herold's reserve appraisals.
Lukoil (LUKOY, news, msgs) trades at $124 a share, or 99% of his $125-a-share valuation. Petrobras (PZE, news, msgs) is $34, or 89% of its $38 appraised worth. By comparison, Exxon Mobil, at $42, is at a 50% premium to its asset value. Cacchione recommends BP (BP, news, msgs) as the best of a generally overpriced supermajor bunch. He likes it because it has similar economic fundamentals to Exxon Mobil but trades at only 131% of reserve values.
Recently Cacchione's strategy has paid off. Over the past 28 months (since December 2001) he claims an average annualized return of 32.8%, against 7.7% for the American Exchange's AMEX Oil index ($XOI.X) and a 0.9% loss for the S&P 500 index ($INX).
Cacchione, 45, began his career as an analyst at Merrill Lynch's real estate subsidiary after graduating from Iona College. Bored with real estate, he answered an ad for a corporate development job at mining outfit Amax in 1984. He spent ten years there, eventually overseeing oil hedging. Cacchione landed at Herold in 1995 as a consultant. After two years he was put in charge of the equity research department. Along with partner Robert Gillon, Cacchione pores over hundreds of company filings every year in order to create valuations of the 125 largest publicly traded oil companies worldwide.
The analysts project the cash stream available from existing reserves by forecasting oil prices and extraction costs. Their spreadsheets stretch out until the point where a company's reserves run out, usually 10 to 15 years. The stocks that ranked high in this analysis -- at low prices, that is, in relation to their reserves -- are then further winnowed by comparisons of other statistics.
In selecting its top picks, Herold analysts prefer oil companies with market caps below, or not much above, the present value of their reserves. The firm then uses other screens like replacement costs per barrel: If that's below $5, the company is adding reserves cheaply.
3 ways to compare
One number is the reserve replacement cost: the cost an oil company incurs to add a barrel to reserves. This gauge includes property acquisition, exploration and development costs, including the cost to build the wells, but not the cost to operate them. Reserve replacement costs averaged $5 a barrel for 200 reviewed companies from 2000 through 2002, when the last complete figures were available. Oil companies that beat the $5 bogey get bonus points. Lukoil, with access to rich, previously almost untouched Russian fields, has a reserve replacement cost of just 74 cents.
| Black gold list | | Company/country | Price | P/E | Market price as share
of oil reserve value* | Oil reserve replacement
cost per barrel** | | Baytex Energy Trust***/Canada | $8.53 | 15 | 46% | $6.31 | | BP#/United Kingdom | 51.20 | 19 | 131 | 4.48 | | Encore Acquisition/U.S. | 27.70 | 13 | 120 | 5.05 | | Lukoil#/Russia | 124.05 | 7 | 99 | 0.74 | | Petrobras#/Brazil | 33.50 | 7 | 87 | 3.54 | | Tatneft#/Russia | 27.82 | 5 | 59 | 2.84 | | Unocal /U.S. | 37.28 | 14 | 107 | 8.14 |
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*Stock market capitalization as percent of projected cash flows from oil reserves. **Buying the land, exploring for oil, building a rig; 2000-2002 average. ***Trades on Toronto exchange. #American Depositary Receipt. Sources: John S. Herold, Inc.; Reuters Fundamentals via FactSet Research Systems.
Second, Cacchione measures how quickly a company is adding to its reserves relative to pumping them out. Fort Worth, Texas-based Encore Acquisition (EAC, news, msgs) added reserves at a rate four times that at which it pumped oil from 2000 through 2002. Encore's main property, in Montana, a worked-over field bought from Shell in 1999, has yielded excellent results, thanks in part to unusual air-injection pumping that extracts the remaining oil.
Third, Cacchione focuses on aftertax net income per barrel extracted, which takes into account extraction and other production costs. In 2002 Brazil's Petrobras did $6.76, 46% better than the worldwide average. Petrobras bought Argentinean oil assets on the cheap in the midst of that country's most recent economic crisis. Despite having doubled in price over the last year, the Brazilian company remains a good buy in Cacchione's eyes. Still, he acknowledges that there's always risk in the turbulent economics of Latin America.
Another intriguing pick is Baytex Energy of Canada, an unusual royalty trust that dumps most of its cash flow out as dividends. This is the cheapest oil stock according to Cacchione's calculation and his only foreign pick that doesn't trade in the U.S. (You have to buy it in Toronto.)
Another cheap oil stock is Russia's Tatneft (TNT, news, msgs), 33% owned by the regional government of the Muslim (and peaceful) Russian autonomous republic of Tatarstan. Tatneft trades at $28, or 60% of its reserve value. The reason for the discount: Tatneft has virtually nil name recognition.
Is Russia too risky to invest in, given the Putin regime's jailing of oil baron Mikhail Khodorkovsky of Yukos (YUKOF, news, msgs) (which is not on the Herold short list)? Cacchione points out that companies like Tatneft and Petrobras have been issuing American Depositary Receipts for years and thus comply with SEC transparency rules. Also, unlike their big U.S. counterparts, the Russian companies have their reserves vouched for by respected third-party firms, making them more transparent than Shell or Exxon.
Copyright 2004 Forbes.com. All rights reserved.
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