Financial Times: Oil companies poised to ride out dip and maintain strength: Saturday 12 November 2005

By Tony Tassell

Published: November 12 2005

The profits of BP this year will at least match the earnings of all 250 companies in the FTSE mid-cap index.

That startling estimate from UBS underlines the importance of calling the oil and gas sector right in the UK stock market. For most of this year, the correct call has been clear-cut. If you bet against the sector, you would have been steamrolled by the surge in energy prices.

But there has been a modest correction since the start of October as oil prices have retreated from the peaks scaled in the wake of Hurricane Katrina. Up to September 30, oil and gas was the third best performing market sector out of the FTSE's 34 UK sectors, rising 33 per cent. Since the start of October, it has been the worst, falling 7.8 per cent.

Part of that fall is just profit-taking after the sector's strong run. But it also reflects a wobbling of confidence in how high oil prices can remain. Prices for West Texas Intermediate have fallen by about 18 per cent from their high of $70.85 a barrel on August 30. With US inventories healthy amid a warm start to the winter in the northern hemisphere, oil prices may remain under pressure in the short term. Industry costs also are rising, oil demand may slow and there have been murmurings of "windfall taxes" on companies.

For some, all this may herald a bursting of the oil share price run. But oil prices have already remained stronger for longer than many anticipated at the start of the year, this columnist included. I suspect the market might now be overly negative towards oil shares. Any temporary oil price weakness now could prove a buying opportunity.

Morgan Stanley points out that on consensus estimates, the UK energy sector is trading on 9.9 times 2006 earnings compared with 11.8 times for the wider market. The broker says there has been a large de-rating of the oil and gas sector since the start of the year as share prices have failed to keep up with earnings growth. In January, the sector was valued on 14 times 2006 earnings, about 30 per cent above the current multiple. Only housebuilders and banks now have lower ratings for 2006.

The sub-market valuation seems particularly anomalous considering the huge largesse of cash being handed back to shareholders by the oil majors. Craig Pennington, energy portfolio manager at Schroders, estimates BP will this year hand back $17.5bn to shareholders in dividends and share buy-backs, equivalent to nearly 8 per cent of its market capitalisation. Similarly, he expects Royal Dutch/Shell to hand back $17bn of cash to shareholders, or 8.3 per cent of its value.

That is remarkable enough but the pay-outs should rise next year. Partly using the proceeds of the $9bn sale of its petrochemicals arm, Innovene, Mr Pennington forecasts BP could hand back $27.5bn to shareholders in dividends and buy-backs or about 12 per cent of its current market cap. Likewise, in RDS's case, the cash returns could be $24bn or 12 per cent of its market cap. It appears the market may be in danger of repeating its mistake this year of being too pessimistic on the earnings forecasts. FactSet JCF, the data company, says at the start of 2005, the consensus of market estimates was for a 4.1 per cent fall in oil sector earnings. Now the forecast has risen to 53 per cent growth amid boom conditions for the oil industry. For next year the market is looking at only 4.2 per cent growth.

This might not be quite pricing in a bust after the boom but implies a downbeat view. This is not without justification. Intuitively, after such a rapid rise in oil prices, a strong correction may seem overdue. JPMorgan points out the average duration of an energy price cycle since 1970 has been 36 months with prices moving up or down by an average of 58 per cent.

The boom has lasted 44 months with a price rise of about 270 per cent. But as has been discussed supply constraints in the industry, particularly refining, are likely to extend the cycle and keep prices high.

There is a wide amount of conjecture about the average oil price analysts are using in their models. Some industry watchers believe the long-term average being used could be as low as $40. That is well below the consensus forecast for West Texas Intermediate oil next year of $56.38 a barrel and $52.50 a barrel for 2007, according to Thomson Financial.

Seth Kleinman at PFC Energy, an industry consultancy, says there is a floor to oil prices at about $50-$55 a barrel. With supply conditions so tight, the Organisation of the Petroleum Exporting Countries is in a strong position to maintain that floor. For equity investors, it would be unwise to bet against such clout. 

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