“Now is a good time to buy.”
That’s what R.S. Sharma, the chairman of India’s national oil exploration company ONGC, said last week.
“The world financial crisis and slumping oil prices have made energy assets more attractive.”
Is he right?
Well, yes and no. It’s a good time to buy oil. But thanks to a few major changes in the oil industry over the years, a great time is likely on the way.
Oil company shares have been in freefall since oil prices topped out over the summer. There are dozens of oil companies trading at prices 60%, 70%, or more below their highs. A lot of them look attractive, but now is not necessarily the time to go “all in” on oil.
Don’t get me wrong, there will be a time to bet big on oil (it’s soon) and the oil profits over the next few years will make the last five years look like a pittance. To comprehend the opportunities in oil we have to examine the massive shifts that have been taking place in the industry.
The People’s Oil
The oil industry has changed a lot in the past few decades. It’s no longer dominated by what the mainstream press calls “Big Oil.”
The fact is, Big Oil just isn’t that big anymore. Sure, ExxonMobil (NYSE:XOM) is posting 11-digit profits every quarter, but Exxon is not really very big. Exxon is only the 14th largest oil company in the world when you compare its oil and gas reserves to other oil companies. There are 13 oil companies bigger than Exxon.
The top 13 oil companies in the world are all national oil companies [NOC]. Before the 1970’s, oil was dominated by private oil companies. The predecessors to ExxonMobil and Chevron were the behemoths of oil. The “Seven Sisters,” as they were known, controlled 80% of the world’s oil and gas reserves for decades.
That all changed over the past 30 years. Most of the world’s oil reserves are now controlled by NOCs. The Financial Times reports the “New Seven Sisters” are all state run NOCs.
For years, this wasn’t a problem. But the shift to NOCs is about to become a big issue.
National oil companies have two purposes. One is to provide the world with oil and allow the states that control them to exert political power. The other is to fund social welfare services.
It’s the second purpose that is the BIG problem.
NOCs at “Work”
You see, for years NOCs have been diverting cash flows out of the company and into government coffers. The cash became a new source of funds for social programs. Diverting oil revenues is an easier political sell than imposing direct taxes. Billions of dollars got diverted away from oil exploration, maintenance, and production infrastructure.
The worst part of it all is NOCs (just like most industries where the government runs interference) are highly inefficient.
For instance, Iran’s NOC was created in 1979. After 28 years of state mis-management, Iran’s NOC produced less oil last year than it did in 1979.
Russian Yukos Oil’s production has flatlined since its nationalization
Hugo Chavez used the profits of Petroleos de Venezuela to fund a large social welfare program.
NOCs can get away with this when oil is selling for $140 a barrel. At those prices, there was plenty of cash to go around. But when oil is $50 a barrel and an NOC still has to pay the same wages, production costs, and other expenses, something has to give.
Typically, it’s the company that suffers, not the social programs. In response to continued demand on their cash flows, NOCs have curtailed capital expenditure to develop new oil fields.
Where to From Here
This exploration pull back comes at a bad time. Our global oil infrastructure is severely underdeveloped. The oil and gas needs trillions of dollars to meet global energy demand.
John Westwood, of oil consultancy firm Douglass Westwood estimates the oil industry is suffering from “two decades of under-investment and [the industry] needs to spend $10 trillion by 2030 to get back on track.”
The International Energy Agency puts the needed investment at $30 trillion.
If not, the IEA warns, “There remains a real risk that underinvestment will cause an oil supply crunch.”
Of course, all of this underinvestment creates a very bright future for oil over the long-term.
No government in the world, especially the United States, has the financial or political will to wean itself off oil in the next decade. It makes for nice campaign talk, but it’s not going to happen.
The world will need more oil. The current economic downturn is going to last a while and oil prices will stay low relative to recent highs, but oil demand is not going to disappear. Just take a look at what happened during the oil shock of the late 70’s through the mid 80’s recession.
Between 1979 and 1983, U.S. oil consumption actually fell 29%. It wasn’t high oil prices though because oil prices remained relatively flat over that period. The biggest cause of the decline was the recession.
How to Get There
The combination of falling oil prices, the ongoing credit crisis, plummeting values of homes (if REIT values are any indication, a lot more downside to come), inefficient state management of oil supplies, and a wealth of other factors have created a lot of uncertainty about the future of oil. That’s why I look to ExxonMobil to see what’s really going on.
Exxon is the most prudent oil company. It routinely posts some of the most efficient operating numbers of any major integrated oil company. Although oil prices have moved up and down, Exxon has always managed to lead the major oil companies in profit margins, operating margins, and overall efficiency.
Most importantly, Exxon didn’t get caught up in the recent oil frenzy. It didn’t ramp up its capital expenditure program and it didn’t go on a shopping spree buying up smaller oil companies when they were richly valued.
Exxon is led by oil men who have been through oil booms and busts.
That’s all why I like to keep an eye on what it’s doing. It’s the steady hand of the oil industry. And what they’re doing may surprise you. Exxon continues to spend about $15 or $16 billion a year on development of new projects. Over the past three years, Exxon has averaged about $14.8 billion in annual capital expenditures and that doesn’t appear to be changing much with the recent downturn in oil prices.
Oil’s Slippery Slope
No, I don’t think it’s time to go “all in” on oil stocks…or anything for that matter. We haven’t reached the point of maximum pessimism yet.
We’re still working our way through the financial crisis and uncertainty reigns supreme. There are just too many unanswered questions out there.
Will the government bailout the U.S. automakers? When will unemployment stop rising? When will mutual fund and hedge fund redemptions stop? How much are corporate taxes going to go up under Democrat-dominated government? Many of the policies, if adhered too, will only extend this downturn (i.e. auto bailout – how many million more cars that no one wants to buy will be produced with government funds?).
It Is NOT Different This Time
Frankly, this recession is going to take a while (keep your eyes on unemployment of around 8.5% for a sustainable turnaround to start) and there will be ample time to pick away at your favorite oil stocks.
History says so. When U.S. oil consumption declined 29% between 1979 and 1983 and oil prices fell more than 60% (like they have over the past few months), it still took 24 years for U.S. oil consumption to return to 1979 highs.
Oil prices and oil stock charts will not be “V” shaped. This downturn is big and most oil companies were overvalued before anyway. As a result, it’s going to take quite a while for many of these stocks to get back to their old highs. But they will.
Remember two things. Cyclical industries always overshoot during good times and undershoot during bad times. This is definitely one of the bad times.
So I agree with Mr. Sharma of ONGC, now is a good time to buy oil stocks. It’s certainly the best time in the last five years to buy them. But we can’t forget to always use a conservative investing strategy to allow us to have to keep some cash on hand for what could be a great time to buy oil stocks.
By Andrew Mickey