Gas Prices: High -- and Staying There

Because the real problems are refining capacity and worldwide demand, OPEC's increased output won't help much, says analyst Kurt Hallead

By Amey Stone

Welcome to a new era of higher energy prices. Even though OPEC announced June 3 that it's raising its production limits by 2.5 million barrels a day in July and August, significantly higher crude and gasoline prices are probably here to stay, says Kurt Hallead, oil services analyst for RBC Capital Markets.

Global demand for oil is only going to increase, while refining capacity in the U.S. will remain severely constrained, he says (see BW Online, 6/4/04, "Why the Saudis Fear Pricey Oil"). Gasoline prices are bound to slip from record levels once the peak summer driving season is over, but it won't be by much, he believes.

That's the bad news. The good news is that Hallead doesn't think higher energy prices will hurt the U.S. or the global economy. Plus, increasing global demand for energy means improving earnings for stocks in the energy sector, including those in the oil-services group he covers, such as Halliburton (HAL ) and Schlumberger (SLB ).

Hallead outlined why energy prices will stay high and the ways for investors to profit in an interview with BusinessWeek Online Senior Writer Amey Stone on June 3. Here are edited excerpts from their discussion:

Q: Let's start with the news of the day: What do you make of OPEC's decision to raise its production ceiling?

A:

Basically the increase just puts the official quota in line with what OPEC countries have already been producing. What may be more important is that several countries, including Saudi Arabia and the United Arab Emirates, said they would add some incremental production.

Q: Do you think the price of gas will come down this summer if the increase in production materializes?

A:

It takes about 45 days for increases in production in the Middle East to reach U.S. shores. I expect gas prices to stay high through the summer and come down as we get into August, partly due to a reduction in demand.

Our forecast is for oil -- now around $40 a barrel -- to average $36 a barrel in 2004 and $34 in 2005. We're not going back to $26 a barrel like we saw in 2001 and 2002. Our broad thesis is that we're in a new era of higher energy prices.

Q: Shouldn't lower oil prices mean lower gasoline prices?

A:

Higher gasoline prices in the U.S. aren't due to problems producing enough oil. The main problem is a bottleneck in refining capacity. There hasn't been a new refinery built in the U.S. in about 30 years, and refiners are running at full capacity now. The additional crude oil we'll be getting from the Middle East is of a heavier grade, and it costs more to refine.

Higher oil prices also reflect supply-interruption concerns, due to fears of political instability and the potential for more terrorism in the Middle East. There is what's known as a security premium in the price of oil, now equal to $10 to $12 a barrel. If you could remove that, it would knock 35 cents off the price of a gallon of gas, but it's not going away.

As long as there's a rise in Islamic fundamentalist extremism in the world, there will be some level of security premium. A year ago it was at $3 to $5 a barrel.

Q: It doesn't seem like higher gasoline prices are having much of an impact on demand so far.

A:

Most economists believe prices have to get to $2.50 or $2.80 a gallon to really have an impact on consumer behavior. Energy spending, as a percentage of disposable income, also hasn't climbed significantly on average yet. Right now, the incremental cost for the average consumer of higher gas prices in 2004 is just 58 cents a day. That's not substantial enough to really alter buying patterns. Demand in the U.S. may cool if prices rise further. By Amey Stone

Q: What about demand outside of the U.S.?

A:

Around the world, demand for oil is increasing. China's per-capita consumption of oil, for example, climbed from 1.58 barrels in 2003 to an estimated 1.75 barrels in 2004. That's still nothing compared to annual oil consumption per capita in the U.S. of 25 barrels.

The trend in China is quite clear. Even if it only gets halfway to where Japan and Korea are (about 16 barrels per capita), I don't know where we're going to get the oil.

Q: Let's turn to your investment outlook. What does all this mean for energy stocks?

A:

Over the next couple of months, we think oil prices will come down from $40 a barrel to the mid-30s, which will be a drag on energy stocks. So for the near term, we recommend investors have a market weight in the sector, or that it equal 4% to 5% of your portfolio. In the intermediate and long term, we think investors should overweight energy, mainly because oil consumption globally is rising.

Q: Which subsectors in energy do you recommend?

A:

Near-term, we recommend investors overweight big integrated oil companies like BP (BP ) and Exxon Mobil (XOM ) relative to other energy sectors, mainly because of their defensive nature. We also recommend overweighting refiners, coal, and energy-technology companies in the next few months.

Over the next 6 months to 12 months, as oil prices settle out in the $30 to $35 range and investor psychology improves, we think investors should underweight the integrated oils in favor of the higher-volatility exploration and production (E&P), energy technology, and oil-service stocks.

Q: Let's drill down -- pardon the pun -- to your area of specialty, the oil-service sector.

A:

These are companies that provide the products and services that help in extracting oil and gas. My thesis for the group is that 2004 will be the year of pricing power (2003 was the year of capacity absorption). Greater pricing power will lead to higher earnings and, at the end of the day, earnings drive stock performance.

Q: Haven't these stocks already rallied?

A:

Since March, many of these stocks have corrected about 10% off their highs as investors began to worry that higher interest rates and higher oil prices would slow economic growth [leading to less demand for oil]. So as oil prices went higher, energy stocks went lower. As a result, many stocks in the group are fairly priced.

Longer term, I believe we're in the midst of a three-stage rally that began in October, 2003. Stage 1 was a value-based rally, as investors bought off the bottom. Stage 2 was a chart-momentum play, as investors followed the stocks up. Stage 3 will be based on higher earnings driven by pricing power. Right now, we're leaving Stage 2 and entering Stage 3. In the third quarter, I expect we'll see upside earnings and revenue surprises.

Q: What are some of your recommendations?

A:

The biggest company I recommend now is Schlumberger, which is a diversified energy-services company. It does about 70% of its business outside the U.S., giving it a great global footprint. International business offers more revenues and higher margins than U.S. business, so they have a good mix.

Halliburton I recommend based on its valuation. It's trading at a discount to its historical multiple, partly due to asbestos litigation, which is winding down, and also due to the politicizing of Vice-President Dick Cheney's former relationship with the company.

Q: What are some small- or midcap names you like?

A:

I have an outperform rating on Smith International (SII ). It makes drill bits and drilling fluids [to lubricate the drill bits]. It will benefit from oil companies' desire to improve drilling efficiency. Also, 60% of its business is international. It has a joint venture with Schlumberger, which gives it access to Schlumberger's global footprint. Nabors Industries (NBR ) is another stock I recommend. It's the largest U.S. land-rig contractor and it also has a growing international presence.

Q: Which energy stocks should investors avoid?

A:

One subsector within the oil-service sector that I would avoid is the offshore supply and transportation business. These are mainly companies that ferry equipment from the rigs to the docks. The main problem there is overcapacity.

I have an underperform rating on GulfMark Offshore (GMRK ). But I have a sector perform rating on Tidewater (TDW ), since it has such a strong balance sheet and free cash flow generation.

So there are some subsectors that will do well and some that won't. But all the oil-service companies tend to trade in a group. That's where opportunities arise.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

Edited by Patricia O'Connell

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