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Plenty of Heat under Oil Stocks

By Tina Vital War rhetoric has escalated, and tensions in the Middle East have simmered for well over a year. And that has helped crude-oil prices surge to about $35 per barrel. No wonder then that the S&P Energy index has outperformed the broader market over that time. The index's 2002 and year-to-date (through February 7, 2003) declines of 11.4% and 3.7%, respectively, stack up well against the S&P Super 1500's (the combined S&P 500, S&P MidCap 400 and S&P SmallCap 600 indexes) loss of 22.5% in 2002 and 5.8% so far this year.

The energy index held up better than the broader market largely because supply constraints and war worries have sustained high oil and gas prices. Most of the sector's outfits met third-quarter 2002 earnings expectations (albeit pared back from earlier guidance in some cases), and fourth-quarter earnings appear to be repeating this pattern. In 2003, earnings growth is expected to accelerate in the second half.

SUPPLY CONCERNS. After the recent surge in oil and natural-gas prices, however, is it too late to buy into energy stocks? Not yet. We at Standard & Poor's recommend that investors should increase their exposure to the sector. Prices of certain stocks have failed to keep pace with the rise in energy prices because of worries over the pace of a U.S. economic recovery in the midst of a potential conflict with Iraq -- and valuations are at multiyear lows. But the American economy is holding up well, given all the geopolitical risk, and S&P expects real gross domestic product to begin rebounding in the first quarter and pick up speed by the summer, raising demand for energy.

In this challenging global environment, concerns over oil supplies are mounting. A prolonged general strike in Venezuela has deprived the market of about 2.4 million barrels per day (BPD) of oil production. U.S. oil inventory levels are now just above what's known as their lower operational level -- the point below which chances of refinery disruptions are increased -- of 270 million barrels for the past month. Possible military action against Iraq could remove an additional 2.8 million BPD of supply from the market, and any spillover effect in Kuwait could wipe out 2 million more BPD.

Despite Venezuela's continued oil strike, production from its fields is gradually returning, although exports are likely to be reduced for some time. To offset the resulting shortages, OPEC raised production quotas by 1.3 million BPD in January and by 1.5 million BPD in February, bringing the current target to 24.5 million BPD. However, if a Middle East conflict leads to a production loss in both Iraq and Kuwait, and with Venezuelan exports still limited, the cartel may not have the spare capacity to meet market demands, raising the chances of a price spike.

SIMMERING PRICES. OPEC is scheduled to meet again on Mar. 11 to review the situation, but an emergency meeting would probably be called in the event of a Middle East conflict. Without a war in Iraq, economic forecaster Global Insight expects prices for the benchmark West Texas Intermediate grade of crude oil to average $26 per barrel in 2003 -- in line with average prices reached in 2002. However, the risk of war remains a wildcard and is likely to keep a fire under oil prices.

In the longer term, with mature producing oil-and-gas fields becoming gradually depleted worldwide, industry sources estimate that nearly half of the current supply will need to be replaced by 2010. Thus, producers will need to spend heavily, which should benefit drilling and oil-field-service outfits. S&P expects international spending to rise over 5% in 2003 and domestic spending to pick up as well.

U.S. natural-gas prices have climbed to almost $6 per million British thermal units (BTU is a widely used measure of energy, with one BTU being the amount of heat required to raise the temperature of one pound of water by one degree Fahrenheit). The price gain reflects accelerated withdrawals from storage because of cold winter weather, sluggish drilling activity resulting from cautious spending by North American producers, and accelerating decline rates of producing fields. (Decline rates reflect the pace at which a reserve is depleted. For example, a decline rate of 50% means that at current production levels, two years of reserves are left to be exploited.) Natural-gas decline rates are over 30% in North America, ensuring that if producers don't spend enough to bring new wells into production, supply will fall, and the market will tighten further, even if demand isn't strong.

DRILLING BOOST. In response to the steady rise in natural-gas prices, exploration and production outfits' discretionary cash flows have climbed, and it's likely that the funds will be spent on boosting North American natural-gas drilling by as much as 50% this year.

So what are S&P's top picks in the energy sector? Among big integrated oil concerns, we like ExxonMobil (XOM) and Total Fina Elf (TOT). In the drilling group, our favorites are Nabors Industries (NBR) and GlobalSantaFe (GSF), and in the oil-field-service group, Weatherford International (WFT). Analyst John Kartsonas, who follows the exploration and production concerns, likes Apache (APA), Ocean Energy (OEI), and EOG Resources (EOG). All of these stocks carry our highest investment ranking of 5 STARS (buy). Analyst Vital follows energy stocks for Standard & Poor's

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