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Get Four
|  | MAY 12, 2004
 SAM STOVALL'S SECTOR WATCH By Sam Stovall Premcor, the Top of the Barrel Looking for a hot refiner? High margins, strong growth, and versatile plants earn this outfit S&P's highest stock rating Just pull up to the pump and you'll figure out why rising oil and gas prices appear to be on everybody's minds these days. So naturally, I wanted to find out if it's too late, from a fundamental standpoint, to buy into some of the stocks of companies that refine and market oil and gas. After all, the S&P refining, marketing, and transportation (RM&T) subindustry index has enjoyed a strong run so far this year -- up 21% through May 7 -- on top of a nearly 40% surge in 2003. While the stocks have put in a high-octane performance, Standard & Poor's Equity Research Group maintains a generally neutral investment outlook for the RM&T segment. Tina Vital, the S&P Equity analyst who covers the group, along with integrated oil-and-gas concerns, says strong U.S. refining margins are being offset by weaker marketing margins -- and by increased spending related to this year's phase-in of new and more stringent gasoline specifications, and the switch-over from fuel additive MTBE to ethanol in some states. As a result, says Vital, the marginal supply cost of gasoline has increased. This has been a factor in the jump in retail prices to near-record highs -- particularly in California, which requires its own unique reformulated blend -- well before the traditional start of the driving season. Further, the spread between the prices for sweet crude oil (lower sulfur content) and sour crude oil (high sulfur content) has widened, because demand for the higher-priced sweet crude oil increased as refineries complied with government mandates to produce lower-sulfur gasoline in North America and Europe. THE COST OF CONFLICT. As a result, S&P expects retail gasoline prices will remain high through the summer driving season, reaching a national average of around $1.95 per gallon -- and peaking over $2 per gallon -- before trending down after Labor Day on reduced demand and increased supplies. Of course, any notable increase in supplies of crude oil or gasoline before than could help bring down pump prices, while unexpected supply disruptions could lead to price spikes. Meanwhile, prices for gasoline's primary input have been near multiyear highs as well. In early May, the U.S. benchmark grade of crude oil, West Texas Intermediate (WTI), had jumped to near $40 per barrel on increased tensions in the Middle East, Venezuela, Nigeria, and Indonesia, which we believe has added more than a $5-per-barrel risk premium to prices. However, the main factor behind high crude prices appears to be stronger-than-expected demand from China and the U.S., which has absorbed excess supply of crude on the world market and kept inventories low. Using projections of world oil supply and demand from energy research firm Global Insight, S&P estimates that WTI oil prices will remain near current levels through the summer, before dropping back toward $30 in the fourth quarter on increased production (particularly from Russia) and reduced demand. HIGH-OCTANE MARGINS. Anticipating this surplus, on Apr. 1, OPEC lowered production quotas to 23.5 million barrels per day. However, given the strength of demand, Vital believes member nations may be finding it difficult to comply. On May 10, Saudi Arabia called for OPEC to raise quotas by at least 1.5 million barrels per day. With the OPEC-10 (member nations excluding Iraq) producing about 2.3 million barrels above their agreed-upon ceiling in April, we view this Saudi call as aligning the cartel's current production to a more realistic target. Given the current outlook for the industry, and for energy prices, which companies in the RM&T group does Vital favor now? Her top pick is Premcor (PCO ), which she initiated coverage of with a 5 STARS (buy) recommendation on May 10. With no side marketing or chemicals businesses, S&P views Premcor as a pure-play U.S. refiner with a strategy of growth through acquisitions. While refining margins are volatile -- and Premcor should have to boost spending through 2005 for environmental compliance -- Vital believes the outfit should benefit from continued strong U.S. refining margins. Vital also thinks Premcor has a strategic advantage due to the complexity of its refineries -- its ability to process different feedstocks, including low-cost, heavy sour crude oil. She notes that it also benefits from lower relative transportation costs for ethanol, a key gasoline additive, with about half of its refining capacity located in the corn-producing Midwest. Industry Momentum List Update For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of May 7, 2004.
* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).  Stovall is chief investment strategist for Standard & Poor's All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
BW MALL
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