Watch Your Step in the Oil Patch

If Mideast supplies are disrupted, big oil's margins could get a major boost. But the specter of global recession makes a glut likely, too

By Heesun Wee

As the U.S. gears up for a battle against terrorism involving regions of the petroleum-rich Middle East, the question arises: Should investors be in the oil patch? Military action in that part of the world could lead to supply disruptions, which would mean a spike in crude prices -- good news for oil companies' margins if the trend is sustainable.

At least for the moment, though, experts say concerns about a possible global recession undercutting petroleum demand are overriding worries about supply ruptures. Reduced demand could lead to an oil glut, which would mean lower crude prices. That's why stocks of major integrated giants, such as Royal Dutch Petroleum (RD ), which includes Shell, oil-services companies including Halliburton (HAL ), and independent explorers and producers like Apache (APA ) have all been hammered along with the rest of the market. "Long-term fears about demand will probably prevail at the end of day," says David Pursell, a director of research at Simmons & Co.

But a collapse in oil prices is hardly in the cards, either, analysts say. One key reason is the shaky economic conditions in nearly all OPEC countries. The oil cartel, whose 11 member nations contribute roughly 40% of the world's petroleum output, have little choice but to give assurances of a stable oil supply because they badly need the revenues.


  At OPEC's meeting set for Sept. 26, analysts expect the cartel to maintain its price target for petroleum between $22 and $28 a barrel, about where oil now trades. Right now, keeping prices at those levels means not raising production levels, which could beef up supplies as demand slacks off and bring prices down.

"We will see anemic oil-demand growth, if [any growth] at all," says J. Marshall Adkins, oil analyst and director of energy research at Raymond James. With demand down, certain oil plays are more likely to be buffered against volatile commodity prices. "History would say that the large, integrated stocks are a much safer haven," says James Carroll, a portfolio manager at Loomis Sayles.

Why? The answer lies in large, integrated companies' business structure. Companies such as Exxon Mobil (XOM ) not only dig for oil, called upstream operations, but also refine crude into retail products such as gasoline and home heating oil, called downstream operations. So while upstream margins are vulnerable when oil prices fall, such integrated companies can make up for that loss in their downstream operations, where prices for retail products are much slower to be hit by lower commodity prices.

Carroll notes that integrated oil companies also have tremendous cash flows, which makes them less sensitive to crude-oil prices. The large cash flows also allow the companies to offer investors substantial dividend yields. And "these companies typically will engage in significant share-repurchase programs. The rest of energy doesn't really do that," Carroll notes.


  Even integrated oil companies' diverse businesses aren't always enough to soothe investors, however. Take Royal Dutch Petroleum. Its shares hit a new 52-week low of $44.81 on Sept. 20, a day after the oil giant lowered its production target. The company reduced previous estimates for average annual growth in oil and natural-gas volumes through 2005 to 3%, from 5%. The stock is now more than 31% off its 52-week high of $65.68, which it reached last Oct. 12.

Refiners, too, usually hold their own when oil prices drop. The thinking is that dips in commodity prices usually take a long time to hit downstream products such as gasoline. But in the current environment, investors aren't buying it. There already seems to be a perception in the markets that lower commodity prices eventually will hit retail crude oil products. Shares of refiner Valero Energy Corp. (VLO ), for example, have been down more than 12% since the Sept. 11 attacks.

Oil-services companies usually feel the impact of lower crude oil prices first. They provide equipment, including drilling rigs and services used to search for and produce oil and gas. When prices drop, explorers scale back on capital spending, which eats into oilfield companies' revenues. Small wonder that shares of Schlumberger Limited (SLB ) hit a new 52-week low of $46.61 a share on Sept. 18. That's 46% off its 52-week high of $86.37 hit on Oct. 12. Other oilfield firms such as Halliburton (HAL ) and Baker Hughes (BHI ) are hovering a few dollars above their 52-week lows.


  Despite depressed oil shares, however, some on Wall Street argue the massive sell-off points to an approaching bottom. And given OPEC's commitment so far to maintaining supply levels, observers don't foresee oil prices collapsing to the $10-a-barrel mark last seen in late 1998 and early 1999 after Asian economies, a key driver of demand growth, collapsed. "I don't think it's likely that we're going back to $10 or $15 oil because the cartel seems to be interested in maintaining discipline," says Carroll of Loomis Sayles.

Carroll adds, though, he wouldn't be surprised if oil prices, now around $26 a barrel, slip to around $20 a barrel in the next three to four months, as demand cools. For one thing, the airline industry is expected to cut operations by roughly 20%. Analysts estimate such a cutback in jet fuel could mean an additional 350,000 to 500,000 barrels of crude sloshing around the oil market.

For most investors, the wisest course might be to steer clear of oil. But for those with a stomach for risk, some exposure might look prescient if oil supplies for any reason are disrupted from the Middle East. Prices would spike, and plenty of companies, from oil-field names to explorers and producers, are now available at prices not seen in months. Severely oversold companies such as driller Nabors Industries (NBR ) and independent oil and gas company EOG Resources (EOG ) could rebound, notes Adkins of Raymond James. Both stocks are sitting at or near their 52-week lows.

Still, it seems the U.S., Europe, and Asia will do what it takes to avoid a supply disruption from the Middle East, considering the ongoing U.S. dependence on imported oil and the already precarious condition of the U.S. and global economy. So if you're not already in oil stocks, this might not be the best time to enter the field.

Wee covers financial markets for BW Online in New York

Edited by Beth Belton