Watch and wait for 2007's oil stock bargains

By Jim Jubak

Is it time to buy the dip in oil -- and oil stocks? Oil prices are down about 35% from their highs of July 2006, and oil stocks have pulled back some in 2007.

ConocoPhillips (COP, news, msgs), for example, is down 10% year to date, Occidental Petroleum (OXY, news, msgs) is off 8%, and even sector stalwart ExxonMobil (XOM, news, msgs) is 1.84% lower as of Jan. 23.

I think the answer is no, not yet. The rally that has lifted the price of oil from $50 a barrel to $54.20 a barrel at the close on Jan. 23 is almost certainly temporary. Supply looks like it's going to be far enough ahead of demand to keep oil inventories high. A slowing U.S. economy will give the oil market some more breathing space.

In addition, oil company stocks face very difficult comparisons in 2006. It will be hard to grow earnings in 2007, even if oil rebounds to $60 a barrel, because oil prices were even higher in 2006. The difficulty of those comparisons is not yet fully reflected in oil stocks' prices. Even after the declines of 2007, the sector is selling at something close to fair value.

The strategy

That said, I don't expect the price of a barrel of oil to drop much below the low $40s in 2007 or 2008. And I think the long-term price of oil is still headed higher. The long-term fundamentals of oil demand say that from the perspective of 2010, 2007 is likely to look like the year the oil market took a short breather.

That leaves me with a short list of oil stocks that I'd keep an eye on for purchase later in 2007, especially if the prices of oil stocks correct further.

Let me explain.

The recent rally in the price of oil is a very good example of a commodity trader's bounce. Unseasonably warm temperatures -- 60 degrees in New York in early January -- had fueled the last leg of the sell-off in oil. So when the weather forecast called for a return to colder temperatures, traders rushed to go long in anticipation of a bounce in the price of oil. They got exactly that, plus an extra bump on Jan. 23 from news stories saying that President Bush would call for doubling the size of the U.S. Strategic Petroleum Reserve to 1.5 billion barrels of oil by 2027.

More downward pressure on oil

If you want to trade that bounce, though, you'd better move quickly. The data arriving from the U.S. Department of Energy over the next few weeks are almost certain to show crude inventories near four-year highs. Gasoline supplies have been climbing, too, with a rise of 3.5 million barrels in the week that ended on Jan. 12. That inventory data will likely produce enough worries about supply surpluses to cancel out the recent bounce.

Another kind of data arriving over the next few weeks will put downward pressure not on oil prices but on the price of oil stocks. Wall Street analysts have been busy cutting their earnings estimates for oil companies for the fourth quarter of 2006 and for all of 2007. Bear Stearns, for instance, has lowered its fourth-quarter earnings estimates of the major oil companies by an average of 9%. Cuts in earnings estimates range from 19% for ConocoPhillips to 18% for BP PLC (BP, news, msgs) to 14% for Occidental Petroleum to 13% for Marathon Oil (MRO, news, msgs). The investment bankers did, however, raise estimates for ExxonMobil by 11% and Royal Dutch Shell (RDS, news, msgs) by 13%.

Outlook from the oil companies

But the problem won't be limited to the fourth-quarter numbers set to be reported beginning with ConocoPhillips on Jan. 24 through Chevron (CVX, news, msgs) on Feb. 2. No, investors will also get to hear about exactly how slow growth will be for most oil companies in 2007. ExxonMobil will see earnings decline by 1.12% in 2007 from 2006 levels, according to the Wall Street analyst consensus. At Chevron, the projection is for a 4.26% drop in 2007. At ConocoPhillips, a 6.89% decline. At Marathon Oil, a 15.91% decline.

It's enough to make the 6.63% earnings growth projected by Wall Street for Apache (APA, news, msgs) look positively stunning.

Wall Street analysts are basing their calls for falling earnings at most oil companies on a belief that oil prices will stay somewhere between current levels and the low $60s a barrel. And they're predicting prices at those levels because they see supply running ahead of demand by a comfortable margin in 2007. From a low of near 2%, spare OPEC (Organization of Petroleum Exporting Countries) capacity as a percentage of demand is headed back toward 4% in 2007, according to Deutsche Bank and AllianceBernstein. That's still way below the 6%-plus spare capacity of 1995 through 2000, but it certainly does give the oil market more breathing room than it's had for years.

Demand in the equation

Of course, that higher level of supply wouldn't be enough to push down oil prices if demand wasn't falling. Due mostly to projections for lower demand from the United States, the International Energy Agency has recently lowered its estimates for 2007 demand by 160,000 barrels a day. Demand in 2007, the agency projects, will grow by 1.39 million barrels a day.

Given this backdrop, oil stocks don't look like especially tempting bargains. Oil stocks historically trade at a discount to the stock market of about 20%, according to Deutsche Bank. That is, the average price-to-earnings ratio for an oil company stock is about 80% of the average for the market as a whole. Before the rally on Jan. 23, oil stocks were trading at about 70% of the market average price-to-earnings ratio. Not overpriced by any means, but no bargain either, especially if earnings are actually set to fall (which would drive price-to-earnings ratios higher, even if share prices stayed flat).

Look for outperformance ahead

Notice, though, that there's nothing in this picture that argues oil will fall back to $27 a barrel, the 20-year average price.

The market will gain a little bit of spare capacity and breathing room, but supply and demand stay roughly in line. And oil should stay well north of $40 a barrel.

One reason for this is that demand for oil in the global economy doesn't fall as much as it used to when prices go up. In the oil crunch years from 1978 to 1983, global oil demand plunged 8.5%, even though world GDP grew by 11.6%, according to AllianceBernstein. Oil-consuming nations reacted to higher oil prices in the 1970s by substituting cheaper fuels for power generation, home heating and industrial use. The use of oil to generate power and for industrial purposes fell by nearly 50% during that period.

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