Searching Out Slick Plays In The Oil Patch

For months, oil prices have swung wildly on the latest Middle East news. They've been whipsawed by fears of war and $60-a-barrel oil one day and by predictions of peace, gluts, and $10 oil the next. Given all of this, oil stocks may seem an unlikely investment haven. But many experts say that, with oil shares below their pre-Iraqi invasion levels, now is a good time to plunge into the oil patch.

Why? The industry has been steadily recovering since 1988. And even if oil prices crash on a Middle East settlement, many experts believe that as OPEC reins in 1991 output, prices will bounce back to $23 or $24 a barrel. That would about match 1990's level and be up from an average of $19.65 a barrel in 1989. Such prices could help earnings of a wide range of oil companies that can stay profitable even at $18 a barrel. Of course, prices and earnings could rise more sharply if a prolonged conflict damages Middle East oil fields, cutting off supplies.

Still, be choosy. Look for companies with low-cost exploration, wide access to crude supplies for their refineries, and sophisticated refining and marketing networks.

Some major integrated oil companies such as Texaco, Exxon, and Royal Dutch/Shell are selling at less than 11 times projected 1991 earnings. They are partially hedged against falling oil prices because their refining, marketing, and chemical operations benefit from cheaper crude. Most also have large natural-gas holdings, which will pay off when new clean-air laws take effect over the next few years.

Since its costly legal scrap with Pennzoil in 1985 over Getty Oil, Texaco has improved earnings by focusing on low-risk projects with quick payouts. It has brought its drilling success rate up to 54% in 1990 from 31% in 1988. Yet it has managed to get footholds in some far-flung frontier areas with enormous potential. At 60 a share, it's selling at about 10 times projected 1991 earnings.

Exxon fetches a higher price-to-earnings ratio but is more stable. Most of the Valdez cleanup costs are behind it. After years of struggling, Exxon is starting to improve its weak exploration record and making better use of its vast worldwide oil reserves. Exxon has more of its refining and production operations overseas than do other majors. That and a strong balance sheet--debt is 23% of capital--will help it ride out a domestic recession and increase 1991 earnings 17%, says First Boston analyst William Randol. Investors also reap a 5.4% dividend.

LEVERAGE. Sticking closer to home, George Gaspar at brokers Baird & Co. in Milwaukee suggests two domestic integrated companies: Kerr-McGee and Phillips Petroleum. Both have good exploration records, solid balance sheets, and lots of new oil production coming on in the North Sea. Earnings at Phillips will rise as much as 15% annually through the mid-1990s, Gaspar predicts. Both have large petrochemical operations that have been hurt by higher-cost oil, but those units should benefit if oil prices stabilize in the mid-20s. And the stocks are cheap: At 27, Phillips sells for about nine times projected 1991 earnings, or approximately 50% of its breakup value, according to Gaspar.

If you're willing to bet on high oil prices, you might want to look at companies with more "operating leverage." Each dollar increase in oil prices boosts British Petroleum's annual earnings by an estimated 9% and those of Amerada Hess by 8%. Pure exploration companies are even more leveraged: Oryx Energy's yearly earnings could rise 18%. But lower oil prices can push earnings down as quickly, since exploration companies don't have other businesses to cushion their fall.

A less speculative strategy is to find companies ripe for restructuring or possible acquisition. Occidental Petroleum, Pennzoil, and USX are candidates. All have large oil and gas assets that are vastly undervalued.

At 65, Pennzoil stock sells for barely half of its appraised breakup value per share. It's down 27% from December, 1989, when it invested its $2.1 billion windfall from Texaco in an 8.8% Chevron stake, starting another legal brawl. If Pennzoil can't soon turn around its weak businesses, which include motor oil and sulfur, analysts believe it will spin them off into separate companies--or possibly sell out to Chevron.

TECHNO-PLAYS. Look for companies that have clearly defined niches, such as specialized markets or emerging technologies. Suzanne Cook, oil analyst for Merrill Lynch Capital Markets, suggests Schlumberger, Baker Hughes, and Halliburton. While all appear expensive, they're supreme in their businesses of providing services for drilling and production, so they can charge higher prices, keeping margins up.

At 55 a share, Schlumberger sells for 16 times estimated 1991 earnings. But the company dominates "wireline" services, which electronically provide critical data from deep in wells about oil formations. The company is also sitting on $1.5 billion in cash. Cook predicts that earnings will grow 20% annually through the mid-1990s.

If you really want a technology play, check out companies dealing in the seismic data that geologists use in finding oil. Cook suggests Landmark Graphics, which sells powerful computer workstations that help process and interpret the data. Oil companies will still need better tools to find crude, no matter what happens in the Middle East.

      Company   Price/earnings ratio *          Comments
      USX              8.1                  May spin off steel unit, making purer
                                            play based on oil reserves; nice 4.5%
      TEXACO          10.1                  Lowest p-e of Big Oil companies; vast
                                            worldwide reserves; exploration record
      KERR-McGEE      10.5                  Large oil production coming on line;
                                            sizable chemical and refining operations
      * Based on 1991 estimated earnings