Politicians Are Demonizing Big Oil? Time to Buy!

Politicians in Washington and cable TV pundits are fulminating over oil industry profits as the average price of a gallon of regular gas approaches $4 in the U.S. Meanwhile, President Barack Obama wants to repeal $46.2 billion of tax breaks for oil and gas producers over 10 years and instead invest in alternative energy. Time for investors to dial back on energy stocks?

Not really, say equity analysts and investors. U.S. oil industry profits continue to exceed expectations as the global economy recovers. On a price-to-earnings basis energy companies are trading at the lowest valuation of the 10 broad industry groups in the Standard & Poor's 500-stock index. In other words, today's stock prices may not fully reflect the high-powered profits analysts see for the sector in 2011. The 41 drillers, refiners, and oil-field service providers in the S&P 500 are projected to earn $134.8 billion this year, up 41 percent from 2010, based on analyst forecasts issued in April.

The sector probably earned $31 billion in the first quarter of this year, a 41 percent advance from the year before, according to Wall Street forecasts tracked by Bloomberg. Earnings upgrades reduced industry valuations to 11.7 times projected 2011 income, from 13.7 in March. "Multiples on energy stocks are very low, and the investment opportunity remains pretty good," says Brian Barish, who oversees $8 billion, including Chevron (CVX) shares, as president of Denver-based Cambiar Investors. His Cambiar Aggressive Value Fund beat 99 percent of its peers in the past year.

Civil strife in the Middle East and North Africa, combined with forecasts that 2012 will see the fastest U.S. economic growth in seven years, sent oil prices up 35 percent in the past year, to $103.88 a barrel on May 10, even after a 15 percent plunge in early May. With gasoline prices up 64 percent since August and the unemployment rate 1.1 percentage points below the 26-year high reached in 2009, industry profits are on a tear.

ExxonMobil (XOM) reported profit of almost $11 billion in the first quarter of 2011, a 69 percent increase over the same period in 2010. Even so, ExxonMobil, the world's largest company by market value, trades at 9.6 times projected 2011 earnings, less than its 23-year median of 15.5 based on reported results, according to data compiled by Bloomberg. Chevron, the second-largest U.S. energy company, trades at 8.2 times estimated income even after a 14 percent advance this year. The company beat analysts' first-quarter profit estimates on Apr. 29; sales rose 25 percent, to $60.3 billion.

President Obama and Democrats in Congress say the profit surge justifies ending tax breaks for oil companies. Obama's 2012 budget would repeal tax breaks for oil and gas producers to generate $18.3 billion in revenue over 10 years. "There is absolutely no reason to continue to subsidize the most profitable companies in the history of the world," Representative Edward J. Markey (D-Mass.), the top-ranking Democrat on the House Natural Resources Committee, said in an Apr. 28 statement. "What is good for the biggest oil companies isn't always what's good for American taxpayers."

Oil executives say such criticism on the tax issue is misguided. "We've paid a total of $59 billion in taxes over the past five years, and that's a significant part of government revenue as well as more than we've earned through our U.S. operations," says Alan Jeffers, an ExxonMobil spokesman. "Any claim that we're not paying our fair share of taxes is inaccurate." Chevron says losing the tax breaks would hurt the industry's global competitiveness. "Discriminatory taxes would put U.S.-based energy companies at a competitive disadvantage around the world and discourage development of domestic oil and gas resources," says Lloyd Avram, a Chevron spokesman.

The White House's efforts to roll back industry tax breaks aren't likely to succeed, given that Republicans controlling the House will almost certainly vote against higher taxes, says Andrew Laperriere, senior managing director at the International Strategy & Investment Group in Washington. "That's the routine we go through every time the price of oil and gas goes up," says Laperriere. "The industry will remain on the defensive and under attack, but the odds remain relatively low of any kind of adverse policy action affecting the industry." Adds Barish of Cambiar Investors: "If you look at these companies' valuations at $100 oil, you have to ask why they're trading at these relatively discounted levels."

One explanation is that some investors think the current profit outlook is too optimistic. The last time oil industry profit forecasts rose this much, in May 2008, things ended badly. Oil stocks peaked that month and began a 54 percent plunge as the recession deepened. Oil reached an intraday record of $147.27 a barrel in July 2008 only to tumble 78 percent, to $32.40 a barrel, in December 2008, six months before the recession ended.

"When everybody is buying into the story that we're going to have high gas prices and they're going to go up forever, that's when I get increasingly incredulous," says Brian Jacobsen, chief portfolio strategist for the mutual fund division of Wells Fargo Funds Management (WFC). "There's uncertainty about the sustainability of oil prices and about whether the energy companies are going to be the favorite political whipping boy."

That uncertainty does not discourage other analysts who see increasing global demand, especially from China, driving prices higher. "I see no deceleration in the demand story," says Alan M. Gayle, senior investment strategist at RidgeWorth Capital Management in Richmond, Va., which oversees $48 billion. "The energy sector remains a good long-term investment." If stocks pull back, he adds, "My take is that you ... buy on weakness."

The bottom line: Robust oil industry profits have made energy stocks attractive, despite public anger over gas prices and the possible loss of tax breaks.

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