What's wrong with oil stocks

By Robert Walberg

ExxonMobil (XOM, news, msgs) said this morning it earned $10.36 billion in second quarter, as oil prices in $70-per-barrel range pushed profit up 36% from the year-ago quarter.

Earlier this week, ConocoPhillips (COP, news, msgs) said its quarterly profit popped 65% from a year ago and BP (BP, news, msgs) said profit soared 30%. Revenues were up by 24% and 13%, respectively.

News elsewhere in the oil patch has been even better. Services and equipment companies Smith International (SII, news, msgs) and Schlumberger (SLB, news, msgs) posted earnings gains of 73%, while drillers Nabors Inc. (NBR, news, msgs) and Diamond Offshore (DO, news, msgs) saw profits surge by 77% and 310%.

Most oil companies are having no trouble beating Wall Street’s optimistic forecasts, with nine major companies beating estimates by an average of 6.7%. They’ve also raised their forecasts, citing strong demand, high crude prices and improved margins.

So why aren’t oil stocks doing better?

Prices can't last?

It seems that Wall Street experts are betting a correction in oil prices is just around the corner. Crude prices jumped 38% from last year, to $65.96 per barrel in the latest quarter from $47.79 a year ago, according to BP. Prices can’t rise like that forever.

Tensions in the Middle East, booming demand from China and India, and supply constraints can’t last, according to the argument. Central banks are raising rates to curb runaway growth and prevent inflation. Meanwhile, oil companies are investing to add production. Add consumer backlash against higher prices at the pump and a possible ceasefire in Lebanon, and you get a case for lower oil prices.

And there’s more evidence that demand and prices may have peaked. The Energy Information Administration, or EIA, reported that domestic demand in 2005 was relatively flat with 2004. Demand for gas is starting to taper as the $3-plus cost spurs fuel economy. The International Energy Agency cut its forecast for worldwide growth in crude demand by some 17%.

Lower valuations ahead

Thanks to these forecasts, Wall Street sees lower valuations for oil firms. The average price-to-earnings ratio for oil services companies is forecast to fall to 15.5 times in 2007, from 19.9 times this year. Drilling and equipment industries should see multiples drop to 8.2 times from 15.4 times.

The problem with these theories is that they are just educated guesses. The stock market has been behind the curve on the rise in crude prices over the past two years. This isn’t the first time a bet was placed on a correction, only to have traders reload on oil as crude moved relentlessly higher.

While rising rates and higher energy prices could trigger a mild slowdown in U.S. growth, there’s little to suggest that the economies of India and China will see much contraction. To the contrary, China just reported its fastest growth in years. Overall any demand slowdown is likely to be minor -- at least over the next six to nine months.

We've seen this before

Reduced tensions in the Middle East would be nice but it seems more like wishful thinking than smart planning. With Iran threatening to use oil as a bargaining chip in its nuclear policy, I wouldn’t bet my money on it.

The same goes for consumer demand. Paying $3 per gallon to fill the tank has people in this country complaining, but behavior should return to normal once the sticker shock wears off -- just as it did when prices first eclipsed the $2-per-gallon rate. Folks in Europe have been paying much more for years yet demand there has steadily increased.

Just as the housing sector defied skeptics with a sustained uptrend, energy stocks remain a good bet to outperform the market into next year. Even if oil backs up a bit, there will be plenty of profits and plenty of increased investment in rigs. Indeed, the rig count today is still well below the peak levels of the early 1980s.

The energy sector underinvested in drilling and equipment for years and it will take more than a couple of good years before supply catches up with demand. Since most companies are contracted through 2006 and most of 2007, drillers and service companies should continue to surprise Wall Street with bullish results.

Look for multiples to more closely reflect current levels, which is especially good news for stocks like GlobalSantaFe Corp. (GSF, news, msgs), Baker Hughes (BHI, news, msgs), Schlumberger and Transocean Inc. (RIG, news, msgs). Given that oil is underrepresented in my StreetPatrol portfolio, I’ll use this opportunity to add all four companies to my holdings as of Thursday’s open.

Robert Walberg is a financial writer based in Chicago, Ill. He was formerly chief equity analyst at Briefing.com. He is a regular guest on CNN's Moneyline. Mr. Walberg ran for Congress in Illinois in 1994.

At the time of publication, Walberg’s family and/or clients had stakes in Exxon, Chevron and Transocean.