A Major Opportunity for Oil Bulls

AUGUST 25, 2011    THE WALL STREET JOURNAL

By LIAM DENNING

Sometimes, it's better to own the guy who makes stuff rather than the stuff itself. That's the case with oil right now.

Oil bulls bidding Brent crude back up on every rumor of a revival in Col. Moammar Gadhafi's fortunes are missing the bigger picture. U.S. economic data on everything from manufacturing to home sales remain weak—and gasoline demand is following suit. China is battling inflation and Europe is mired in its ongoing fiscal crisis.

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Given the risks of a correction in oil prices, better value can be found in the stocks of major oil producers.

Yet Brent crude, at about $110 a barrel, remains 15% above where it began the year. Moreover, Wall Street is forecasting an average price for 2011 of about $106 for the year, according to FactSet Research Systems. Given prices year to date, that implies Brent needs to average just under $95 for the rest of the year, 14% below today's level.

Brent prices clearly don't discount a recession. If they did, they would be closer to, or below, the marginal cost of supply, which Sanford C. Bernstein pegs at $80 to $90 per barrel. Perhaps they reflect hopes of another round of quantitative easing from the Federal Reserve. But a resort to QE3 would signify that the underlying economy—you know, the place where oil actually gets burned—is very weak.

Given the risks of a correction in oil prices, better value can be found in the stocks of major oil producers. They have fallen even more sharply in the recent selloff, with Exxon Mobil off about 10% since the end of June compared with Brent's fall of less than 4%. Remarkably, Exxon, Italy'sEni and France's Total are actually valued lower now than they were at the end of 2008, when the world really did look like it was ending. Since then, Brent has more than doubled.

The stocks of Europe's major oil companies are priced for a long-term Brent price of $75, according to Citi. That provides a cushion against further declines in the commodities markets. In addition, they offer investors high cash payouts in the form of dividend yields and share buybacks that commodities can't compete with. On average, Exxon, Chevron, ConocoPhillips, Royal Dutch Shell, BP, Eni and Total yield 5.5% on dividends and 9.3% including buybacks, according to Credit Suisse.

What's more, given strong balance sheets in general—Exxon now scores higher than Uncle Sam, at least in the eyes of Standard & Poor's—it would take a prolonged recession with Brent stuck at $70 or below for a year to endanger payouts, reckons brokerage Raymond James.

The cheapest stocks are Eni and Total, in part because of their Italian and French provenance, where sovereign-debt worries reign. Shell, meanwhile, is just exiting from a multiyear period of spending that will fuel output growth of about 3% per year to 2014, according to Credit Suisse. Yet its stock commands less than seven times 2012 earnings and yields 5.3%. That looks safer than relying on further explosions in the desert.

–twitter.com/liamdenning