Oil Stocks: Only Patient Investors Need Apply

Inventories are up, and prices are likely to fall -- not a recipe for quick profits

Like texas wildcatters, stock market investors have charged into the oil sector this year -- and they've hit a gusher of profit. While the overall market has gone nowhere since the start of the year, since the start of the year, shares in ExxonMobil (XOM ) soared 22% through Mar. 2, while ChevronTexaco (CVX ) rose 18%, BP (BP ) 11%, Royal Dutch/Shell Group (RD ) 10%, and France's Total (TOT ) 8%. Those are only the latest surges in a two-year rally that has sent the collective market capitalization of the oil world's Big Five up a phenomenal 72%, to $1.14 trillion, since early 2003.

All that has raised questions about whether a bubble is forming in energy stocks. Vanguard Group was so concerned about piling on that it closed its Energy Fund (VGENX ) to new accounts in December for a "cooling-off" period after it had racked up a 55% annual return.

So is Big Oil still worth owning? For long-term investors, probably yes. Stock prices aren't as high as they would be if investors really thought today's high oil prices were here to stay. Michael Mayer of Prudential Equity Group (PRU ) uses historical patterns to project how much oil companies can expect to earn at any given oil price, and what stock prices should be based on those earnings expectations. By that analysis, he figures investors are braced for oil prices to drop gradually to below $30 a barrel by 2007. That's plenty cautious, considering that crude hit $52 a barrel on Mar. 2, and Saudi Oil Minister Ali Naimi said as recently as Feb. 24 that he expected prices to range between $40 and $50 a barrel for the rest of 2005.

Stock prices also look moderate in relation to expected earnings of oil companies. Thomson First Call says that the price-earnings ratio of the sector, based on analysts' predictions of 2005 profits, is 14, vs. 16.4 for the overall Standard & Poor's 500-stock index. The only sector with a lower forward p-e is finance.

In contrast, momentum players looking for a quick kill had better watch out. With stockpiles of crude and gasoline rising, there's a good chance that oil prices will fall at least a little. And history shows that in the short term, when crude falls, stocks also fall. Going back to 1989, Prudential's Mayer found that oil stocks underperformed the Standard & Poor's 500 in 29 of the 33 periods when oil prices fell 15% or more. "All of energy's going to have a short-term pullback," predicts John P. Herrlin Jr., a Merrill Lynch & Co. (MER ) analyst and a long-term bull on oil stocks.

That's because supply is exceeding increased demand, despite strong economies in China and the U.S. and troubles in oil producers from Russia to Iraq to Nigeria. The Energy Dept. says that as of Feb. 25, U.S. crude inventories were up 9% from the year before, while gasoline supplies, despite a worrisome drop in refinery usage, were up 10%, above their five-year averages.

Hot money from hedge funds and other sources has flowed into oil this year, both chasing the rise in stock prices and contributing to it. But those momentum investors could abandon oil at the first sign of trouble. So while oil stocks look good long term, don't count on capital gains to keep gushing this year.

By Peter Coy in New York

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