Energy Stocks: The Economic Recovery May Be Slow

Chevron's earnings warning and other downbeat forecasts mean investors may have to wait longer for a recovery

Stocks in the energy sector slipped on Apr. 13 after Chevron (CVX) warned of "sharply lower" profits, underlining expectations that the sector's earnings face a rough first quarter.

Yet many investors continue to stick with energy stocks. After a steep decline in both energy shares and the price of oil and other commodities last year, many still hope for a revival for big oil and other energy companies in the second half of this year. So far this year through Apr. 9, the S&P Energy index has fallen 6.3%, vs. a 5.2% drop in the S&P 500 index. But some groups within energy, such as oil and gas drilling and energy equipment and services, are up for the year.

The main dispute between energy bulls and bears: the state of the world economy, and whether a recovery is coming soon or later. The global economy will have a direct effect on the demand for oil and other energy sources. For big energy companies like Chevron, Exxon Mobil (XOM), ConocoPhillips (COP), and BP (BP), "oil and gas prices are the main driver for the bottom line," says Tina Vital, equity analyst at Standard & Poor's. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies.)

No Relief in 2009

Chevron's announcement, issued late on Apr. 9, caused stock analysts to cut their earnings expectations sharply for the oil giant, which will report full results on May 1. The main culprit is the price of oil, which has slashed Chevron's profit margins throughout its business operations. "It's a very tough pricing environment for crude oil," says Ben Halliburton, chief investment officer at Tradition Capital Management.

On Apr. 10, the International Energy Agency said it expects global demand for oil to drop 2.8% in 2009. The IEA cited "a growing consensus that economic and oil demand recovery will be deferred to 2010." On the NYMEX on Apr. 13, crude oil prices dropped 4.5%, to just below $50 per barrel. Last July, oil hit a peak of $147 per barrel.

The global recession has destroyed demand for crude oil, says Halliburton, who is pessimistic about the prospects for an economic rebound any time soon. "Recovery this year in the economy is a pipe dream," he says. A "muted" recovery could arrive in the early part of 2010, he says.

However, Hodges Capital Management energy analyst Mike Breard points out that world governments are "throwing so much money into the system, eventually it's going to help." He predicts a rebound in oil prices in the second half of 2009. That's driven not just by economic recovery, he says, but also a slowdown in drilling by the industry and the depletion of existing wells. Oil prices should also rise if the world experiences a bout of inflation or the U.S. dollar weakens, he adds. S&P's Vital agrees. "Most people believe that this dip in oil prices is temporary," she says.

Robust Production

The problem with predictions of oil prices, however, is that commodity forecasters are notoriously unreliable. Edmund Cowart, portfolio manager at Eagle Asset Management, says oil companies "can't control the prices they receive." However, they can control other factors, and Cowart believes Chevron is doing a good job (he owns Chevron shares).

While the industry as a whole is cutting back on new drilling and seeing existing wells dry up, Chevron is expected to increase production by a healthy 4% in 2009. In the first quarter, Chevron said it has increased production through repairs of Gulf of Mexico facilities damaged by hurricanes last year. Several other international oil fields are expected to bear fruit in 2009 and beyond, analysts say.

Cowart adds that Chevron seems to be controlling costs in its refineries—even though profit margins for the refining industry are getting squeezed by low oil prices. "We think they're doing a pretty good job" with the things the company can control, he says.

Shrinking Demand

For bullish energy investors, the one bright spot is China. According to Ed Yardeni, president of Yardeni Research, China's "stimulus program may be starting to work already." Car sales and iron ore imports hit a record in March; industrial production rose 8.3% from the year before; and crude oil imports reached a one-year high, Yardeni wrote in an Apr. 13 note.

But, assuming such encouraging numbers are sustainable, there is no guarantee that fast growth in China will be enough to make up for shrinking demand in the rest of the world.

When oil prices and the world economy recover, investors could see lots of upside in energy stocks. But if the global slowdown lingers or worsens, even oil's current price of $50-per-barrel may be seen as overly optimistic. And shares of even the best-run oil companies will feel the consequences.

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