Oil Stocks Look Like a Dry Hole


by Christopher Palmeri It has been a chilly week for energy stocks, but not because temperature in much of the U.S. are so low. Royal Dutch/Shell's (RD) Jan. 9 disclosure that nearly 20% of its oil and gas reserves were overstated has cast a pall over the sector. Meanwhile, the Commodity Futures Trading Commission has begun an investigation into alleged natural-gas price manipulation at the New York Mercantile Exchange. Although shares of major oil companies such as Exxon Mobil (XOM), BP (BP), and ChevronTexaco (CVX) have recovered some of the ground lost since Shell's announcement, they're all still trading below their recent highs.

All in all, it's a tough start to what may be a difficult year for energy outfits. Many industry pundits had expected oil prices to fall sharply after the Iraq war. Instead, lingering hostilities in Iraq, coupled with supply disruptions elsewhere in the world and a new sense of solidarity at OPEC, have helped keep energy prices aloft. Oil sold recently for $34 a barrel, $2 above what it traded for at the start of 2003, when fears of an Iraqi war were on the rise. Natural gas sells for $6.30 per million BTUs, 20% higher than a year ago.

As a result of those high prices, oil companies are expected to report strong earnings over the next few weeks. Lehman Brothers analyst Paul Y. Cheng figures the 16 major companies he closely follows will earn a combined $14 billion in the fourth quarter, an 18% improvement over 2002. But those expectations are already priced into oil stocks.

CLOSER SCRUTINY. And few expect the good times to last through this year. Oil production is increasing in places like Nigeria, Algeria, and the former Soviet Union. The consensus among Wall Street analysts is that oil prices will fall to an average of $25 a barrel and gas to $4.50 per million BTUs for the full year 2004. A 25% drop in oil prices could hamper oil producers' profits, and rising refinery production is already crimping margins in the gasoline business.

At the same time, tighter scrutiny of reserve disclosure in the wake of the Shell announcement could result in rival outfits ratcheting down their own reserve estimates. "A reclassification of this magnitude is catching the attention of not just the investors in Shell but other watchdog groups," notes Lysle Brinker, an energy-stock analyst at independent research firm John S. Herold. "This is only likely to increase the pressure from investors to make sure companies are more careful and forthcoming." Any findings of impropriety could dampen trading at the Mercantile Exchange.

Already, the number of rigs drilling for gas in the U.S. has jumped 34% in the past year, creating the prospect of a lot more supply. For that reason, George Gaspar, an energy analyst at Robert W. Baird & Co., suggests that investors stay away from gas-heavy independent producers and focus instead on oil-field service stocks that should benefit from the increased drilling. His top picks include Oceaneering International (OII), a provider of diving and transportation services for offshore rigs, and Smith International (SII), a maker of drilling supplies.

SCATTERED OPPORTUNITIES. Some analysts do see opportunities in oil and gas producers. Jacques Rousseau, an energy analyst at Friedman, Billings, Ramsey & Co., looks for outfits that boast the rising outputs that could offset falling commodity prices. To that end, he likes French giant Total (TOT) and Los Angeles-based Occidental Petroleum (OXY). He figures production growth at both companies should exceed 5% this year, vs. 1% to 3% for their peers.

Deutsche Bank Securities analyst Jay Saunders is recommending Marathon (MRO), in part because of its potential in Libya, where local despot Muamar Quadafi swears he has turned over a new leaf and is working to lift U.S. sanctions. Marathon has a 16% interest in Oasis Group, a billion-barrel Libyan field it was forced to leave in 1986. Winning reentry to the country could give Marathon's stock price a big boost.

Yet gains in these stocks could prove to be the exceptions. The oil industry has always been full of surprises -- but investors have little reason at this point to expect any huge upside in 2004. Palmeri writes for BusinessWeek from the Los Angeles bureau


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