SECTOR SCOPE by James A. Anderson Aug. 2, 1999

Oil Stocks: A Pleasant Reversal of Fortune
They've already risen, in lockstep with crude prices, but it isn't too late to catch a hot group on its way up

A cyclical business if ever there was one, oil follows a predictable pattern. First, thereís a gusher of demand (sometimes camouflaged as a dearth of supply). That prompts hordes of producers to fan out and find a new fountain of black. In a matter of time, new supplies lead to a glut and prices fall. In turn, dirt-cheap fuel sparks a spike in demand that sets off the cycle anew.

Oil stocks tend to mimic that pattern. After all, higher oil prices boost industry profits and trigger a rush on the shares of everyone from Exxon to Shell. Witness what happened over the past few months as crude prices jumped to $20 a barrel just after many experts predicted that they would peak at $14 this year.

Oil stocks have become market beaters, a mere year after it seemed that gravity had them in a hammerlock. Shares of the leading oil and gas exploration and production companies have risen an average 24% just in the past three months, and 33% for the year. In 1998, the same group slid 39%. Domestic integrated companies, which work every facet of the business from the drilling rig to the filling station, have a 16% rally going the past 13 weeks and are up 26% so far this year. Last year, their segment slipped 21%.

TIGHTENING MARKET. Indeed, what went wrong for oil in 1998 is suddenly going right in 1999. To stem an oversupply of oil, ministers from the Organization of Petroleum Exporting Countries (OPEC) cooked up a plan in March to withdraw as many as two million barrels a day from the market. Then Asiaís slumbering economies awoke and pushed up worldwide demand. Still, you have to wonder: Now that oil shares of rebounded so smartly, are they ripe for a fall?

The answer is: No, not yet. Start with the fact that crude oil prices began the year low and by February had sunk to their lowest inflation-adjusted level since the 1950s. Add a rebound in worldwide demand, which should climb 1.6% this year vs. last year's anemic 0.6%, according to John H. Lichtblau, chairman of the Petroleum Industry Research Foundation. Thatís still short of the annual 2% to 2.5% increase recorded during much of this decade, but it is a sign that the market is tightening.

The industry can thank OPEC members for adhering to the cutbacks the group adopted for 1999 and early 2000. In fact, the cartel's current 26 million barrel-a-day production rate is low enough that petroleum stockpiles could soon dwindle to their lowest level since late 1996, says Bear Stearns analyst Frederick P. Leuffer.

Put it all together and there isn't much downside for the oil companies, says John S. Segner, portfolio manager of the Invesco Energy Fund. "Look at the big picture, and you see that demand is running about 95% of supply," he says. "There's not a lot of room for any disruptions -- and that's not even counting the fact that equipment has to be shut down for maintenance." Nor is it counting the kind of political unrest that always seems to crop up when oil inventories are tight. One example: Nigeria, where ethnic tensions are a threat to oil production.

If that isn't enough to keep oil industry profits on track, consider that the recent spate of mergers in the industry should yield some sizable cost cutting in the near future. BP Amoco has estimated that it can shave $3 billion from expenses, while Shell looks to sweat off $2.5 billion.

Y2K PROFIT SURGE. Bear in mind, too, that oil sector earnings don't yet reflect the full impact of the recent hike in crude prices. While oilís profits for 1999 may not be all that impressive, Zacks Investment Research predicts a big earnings boost next year. The bottom lines of oil exploration and production companies such as Apache Corp. (APA) and Noble Affiliates (NBL) are expected to leap 50% in 2000; for domestic integrated companies such as Amerada Hess (AHC), Wall Street is looking for a 42% increase. For international mammoths such as Chevron (CHV) or Exxon (XON), according to analysts surveyed by Zacks, earnings in 2000 could rise 25% or so.

All the same, you may be feeling that youíve missed out on oilís resurgence. Not quite. Upstream companies -- industry lingo for the folks who coax crude oil from the earth -- may have largely had their day. But many of the "downstream" companies that process oil or hawk it to you and me havenít. "Downstream players such as refiners were squeezed when crude oil prices rose," says Bear Stearns' Leuffer. "Low gasoline prices meant they couldnít pass their oil costs along to consumers."

As a result, stocks of six refiners tracked by Standard & Poor's have fallen some 7% so far in 1999. Look for that to change soon. Peak driving season has already started tugging gasoline demand and prices higher. In the past month, the average cost per gallon has risen 7%. And recent refinery fires on the West Coast will likely raise what youíll pay at the filling station as well.

Thatís good news for a stock like Tosco (TOS). After a run of acquisitions dating back to 1993, it is now the No. 1 U.S. independent refiner. Not only that, it has a significant retail presence on both the East and West Coasts, giving it a second way to profit from higher gasoline prices. And with its refining peers in a bind, Tosco might opt for an acquisition to help spur earnings this year. Currently, 10 of the 14 analysts who cover Tosco rate the company a buy or strong buy, while Wall Street looks for the company's earnings to rise 32% in 2000, then 15% annually over the next five years, according to Zacks. Over the next 12 months, Bear Stearnsí Leuffer thinks Tosco can reach a price target of $41 a share. The stock closed at $26.38 on July 30.

USX-Marathon Group (MRO), with operations in exploration, production, refining, and marketing, looks to be a reasonably priced play on the industry at large. The company could benefit from apparently perfect timing: thanks to projects begun over the past few years, Marathon could boost production an average 7% over the next few years, compared to the 0% to 3% most others will report, says Leuffer. "Youíre seeing the results of some very good investments three or four years ago that are coming on line now," says Invescoís Segner. Of the 22 analysts who follow the company, 18 rate Marathon a buy or strong buy, according to Zacks. The Street expects the company to boost earnings 44% in 1999, and an average 17% annually over the next five years. Lueffer says the stock, which closed at $30.38 on July 30, could reach $38 within 12 months.

If you would rather have a mutual-fund manager run interference for you, there are a couple of pretty good options: The Excelsior Energy & Natural Resources fund (UMESX) and the Invesco Energy Fund (FSTEX), which rank No. 1 and No. 2 in Morningstarís Principia database of funds based on their load-adjusted three-year average annual total returns. Excelsior, which sports a 15.36% average annual return over the past 36 months, is up 28.68% so far this year. Invescoís fund has averaged a total return of 12.36% annually over the past three years, and is up 38% so far in 1999.

James Anderson teaches journalism at the City University of New York _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

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