Oil: After the Storms, the Sun?


By Joseph Radigan Shares of the major oil companies hit their peaks for 2005 in late September and have declined ever since, with many of the largest companies in the group off 14% or more amid concerns about economic growth and energy demand. However, that trend should soon reverse itself, says Tina Vital, who tracks the integrated oils and refiners for Standard & Poor's Equity Research. She sees the dropoff as a buying opportunity.

While upstream production and refinery outages from Hurricanes Katrina and Rita in the U.S. Gulf Coast remain, Vital expects high oil prices and strong refining margins will more than compensate for these storm losses during the third-quarter earnings season. There was much media hype regarding declines in economic activity and oil demand, but Vital thinks that the Gulf storms had little impact on global economic growth. And she expects oil demand will continue to be strong.

RECORD REFINING MARGINS. Using data from Global Insight, Vital projects a pickup in oil demand going into the fourth quarter as well as next year. Plus, Global Insight sees global oil demand growing by 2.11%, to 85.16 million barrels a day in 2006, vs. a gain of 1.54% in 2005. As a result, S&P expects oil and gas prices will remain firm through the winter. In Vital's view, the major oil companies should be set to report substantial earnings advances in both the third and fourth quarters.

Moreover, in the aftermath of Hurricanes Katrina and Rita, global refining margins moved to record levels, Vital says. For the past three years, the U.S. refining margins averaged more than $6 per barrel. Shortly after Katrina and then Rita tore through the Gulf Coast, U.S. refining margins soared above $30 per barrel -- and Northwest Europe and Asian margins followed the trend.

Gasoline spreads rose to more than $33 per barrel in New York Harbor and to nearly $55 per barrel in the Gulf Coast. Meanwhile, Gulf spreads for distillates (heating oil, diesel, and jet) jumped to nearly $70 per barrel. While narrowed gasoline spreads have led U.S. refining margins back to nearly $18 per barrel (as of mid-October), Vital notes this amount is still three times the average level over the past several years. Distillate spreads continue to be very high.

STILL SOME OUTAGES. "We project global oil and U.S. natural gas prices will remain strong through the winter, and U.S. refining margins will remain in the double-digit territory through the fourth quarter," Vital notes.

However, not everything is rosy for the major oil concerns -- upstream production and downstream refinery outages continue in the U.S. Gulf, and U.S. marketing margins reached negative territory in the aftermath of Hurricane Katrina. Also, chemical earnings are expected to be down from last year and the second quarter, reflecting high energy and utility costs.

ExxonMobil (XOM

; ranked strong buy; recent price: $57) is due to report its third quarter on Oct. 27. Vital is looking for a 57% increase in its operating earnings per share, to $1.51. Similarly, when Chevron (CVX

; strong buy; $58) issues its results on Oct. 28, Vital anticipates a 49% rise in per-share operating earnings, to $2.06. She also expects a 73% jump in the operating earnings of ConocoPhillips (COP

; strong buy; $63), to $2.52 per share on Oct. 26; and a 108% climb in the operating earnings of Total SA (TOT

; strong buy; $124), to $4.92 per ADR on Nov. 4.

"SHORT-TERM GLITCH." Among the pure-play refiners, she expects per-share operating earnings to rise more than threefold for both Valero Energy (VLO

; strong buy; $102), the largest refiner in North America, as well as Sunoco (SUN

; buy; $72). Vital expects Valero to post operating earnings of $5.07 per share on Oct. 31 and Sunoco to report operating earnings of $2.97 on Nov. 3.

"Basically, we're looking at the storms as just a short-term glitch," Vital observes. "World economies had a lot of momentum before the Gulf storms and appear solid in their aftermath." S&P projects world real-GDP growth will remain steady at 3.2% through 2007 and expects U.S. real-GDP growth will average 3.5% in 2005 and 3.2% in 2006 -- with about 70 basis points cut from U.S. real-GDP growth in second-half 2005. But the same amount is expected to be added back in 2006 on rebuilding, according to S&P. The hurricanes added an energy-supply shock on the heels of an energy-demand shock -- causing oil and gas prices to surge.

Given the lack of spare oil-production capacity worldwide, Vital expects oil markets will remain tight for some time. Prior to the hurricanes, West Texas Intermediate (WTI) crude-oil prices climbed above $60 per barrel and raced past S&P's forecast. Apart from the brief spike above $70 in Katrina's wake, crude prices have eased somewhat and are now about $61. "While WTI oil prices have dropped $10 since the end of August, we don't expect much more price erosion, and they have moved back in line with our pre-storm projections," Vital says.

HUMMING ALONG. Global Insight and Standard & Poor's project that WTI oil prices will decline from $63 per barrel at the end of this year to $54 by the end of 2006. S&P thinks they will remain above $45 through 2008, which is still high by historical standards.

Meanwhile, with natural-gas production losses mounting in the U.S. Gulf, S&P believes that levels will fall short of the projected target of 3.2 trillion cubic feet in storage by the end of October. Therefore, S&P expects U.S. Henry Hub bid week (blend of spot and contract) prices to remain near $13 per million BTU through the winter season and average $8.61 in 2005 and $9.56 in 2006. With world oil demand seen as growing strongly and energy markets tight, Vital says the major oil companies will continue to benefit.

Radigan is senior editor for Standard & Poor's weekly investing newsletter, The Outlook


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