How to profit from soaring oil prices
By October, the oil price could well have reached $90 a barrel. That might mean sky-high heating bills and even higher petrol prices - but smart investors can turn the situation to their advantage. James Ferguson talks about the best ways to make money from oil.
The oil price is back at new record highs. Higher pump prices are already a reality and sky-rocketing winter heating bills an inevitability.
Meanwhile, the drag of higher transport and utility costs suggests economic growth will slow further. But an insensitively timed, global tightening by central banks suggests the situation could be exacerbated and is already knocking the government bond markets for six from Japan to Milan.
Fortunately, there are winners as well as losers and some of the winners are looking extremely good value. There's no doubt we could even turn this situation to our advantage and I'm going to use BP (BP) to illustrate how.
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Oil price could reach $90
As we celebrated Christmas in 1998, the crude-oil price quietly dipped to just $10.70 per 42 gallon barrel (that's about 4p a litre). Since then barring 2001, when post-dotcom economic weakness caused oil prices to halve each peak and trough has been higher than the one before. Last week, amid much press fan-fare (rather as if it were a new story), the oil price reached another new high and, unless something extraordinary happens in the next few weeks, oil will almost certainly go higher. Although the price whip-saws about a bit, the mid-trend line of the last three years goes right through $80 around the end of August.
However, it's likely that the oil price will actually reach $85 or even $90 by September/October. For starters, the oil price has not one, but two seasonally strong periods each summer. The first is around now and relates to what's called "the US driving season". Each summer, as we Brits squeeze into charter planes taking off for all points south (only to complain that the Germans got there first), American families all get into their camper vans and head for the hills.
In anticipation of the increased gasoline demand, light sweet crude-oil prices almost always spike around April/May. Then, after what is usually a brief profit-taking dip in May/June, hurricane season is upon us. Warmer sea temperatures do seem to be giving us more really serious hurricanes. With a lot of drilling in the Gulf of Mexico and a significant proportion of America's refining capacity lined up along the low-lying Gulf coast, production and refining outages have proved significant for the last two years. Low oil prices may have contributed to global warming, but in this case, global warming leads back to higher oil prices.
Is oil inflationary?
There are two schools of thought about the effects of higher oil prices. One school, dating back to the two oil shocks of the 1970s and early 1980s, asserts that higher oil prices usher in inflation. This makes sense: not only do we buy oil to fuel our cars, power our electricity and heat our homes, but nearly everything else we buy from food in local shops to airline tickets also has transport costs built in.
But the oil shocks saw huge increases in other commodity costs too. The Commodities Research Bureau (CRB) index of all commodity prices has just got back to its 1980 peak this year, which means that for the last 25 years commodity prices have been falling in absolute terms. Thus oil wasn't the cause of inflation, but one of the symptoms.
Another significant factor is that our economy is much less industrial these days than it was then and so power and transport costs have a proportionately lower share of GDP. It is estimated in the US, for example, that while more than half the rise in commodity prices in the 1970s passed through into the producer price index (PPI), only about a third did so during the 1982-1989 cycle, and this time it's perhaps just 20% so far.
Most importantly, higher commodity prices only trigger widespread inflation if they lead to what economists call wage-cost-push inflation. As long as workers don't, or can't, demand higher wages to compensate them for rising costs, higher oil prices will have no multiplier effect and year-on-year increases will die out the following year. Both US and UK government statistics on inflation are so heavily doctored these days (to the extent that some components are excluded from the basket if their prices rise a practice known as substitution') that relatively few inflationary effects make it through.
Another reason why commodity price rises have failed to ignite higher wage demands is the China Effect' of lower wages in developing nations combined with global free trade. Although developed world corporate-profit margins are at, or near, long-term highs, unit labour costs are growing at under 2% in the US and are actually negative in Germany and Japan. Very high profit margins also mean firms aren't forced to pass on input costs, such as higher oil costs, which is another reason for the low 20% pass-through of higher commodity costs into PPI.
But higher fuel and utility costs affect consumers, of course. The alternative school of thought claims this effect acts like a tax, dampening consumer confidence and eating into consumption that would have been spent elsewhere. In America, where fuel taxes are lower and hence increases in oil costs are felt more acutely, it is already estimated that it will cost the average two-car family $1,000 more this year and fuel bills will be at least 25% higher than in 2005. Combined with the first negative savings rates since the Depression, this has to curtail US consumption.
The cost of things to come
It may well be that in the end more of the oil price rises are passed through into inflation because there are delays that still haven't fully kicked in. In February, there was uproar in the UK press when British Gas announced price hikes of 22% for the coming year. The cause? Last year's rising gas prices. Today's oil price is next year's painful fuel bill. The bad news about higher petrol-pump prices and gas and electricity bills down the line is inevitable. So is there anything we can do about it?
What about interest rates?
The issue to work out is what effect oil price rises may have on the interest-rate environment. The only counter to the old-fashioned oil-shock type inflation was to raise interest rates and raise them a lot. But if the inflationary effect is now more muted than in the past, as it seems to be, then the oil-price rise acts as tax-hike' school of thought prevails.
According to this view, higher oil prices will slow economic growth, which is probably already apparent, and interest rates can be expected to fall. They've already been flat in the UK since last summer, but it would imply the US is closer to ending this interest-rate cycle than is generally thought. That suggests the worldwide collapse of developed-world government bond markets may not continue unabated for too long either.
But there's a catch. Inflation may be low' in some senses, around the 2%-2.5% mark, but it's still running at multi-year highs. More and more City economists now expect that the Bank of England's Monetary Policy Committee's next move on interest rates will be to raise them again. Steven Nickell, the remaining dove, retires after the next vote.
The raise is anticipated because, if you were a central banker and were to open your handbook at the section that deals with high corporate-profit margins, strong labour-productivity growth and above-target consumer price index, you'd find yourself looking at the chapter on profit-push inflation. In a nutshell, contrary to what they say, corporates do have pricing power sufficient to prevent labour productivity fully feeding through to lower prices. The prescribed way to deal with that is to curb final-demand growth with higher rates. Hence there is still the risk that central bankers push rates too high, or for too long.
Where will the commmodities story end?
So what can we do? We seem to have higher pump prices this summer and higher heating bills next winter written indelibly into the script. While that inevitably means slower economic growth, the world's central bankers are currently embarked on a concerted global monetary-tightening policy. In the UK, we've got higher taxes to look forward to as well. Is there something we can do to alleviate these woes? Luckily, there is.
Question: what happens when one asset class commodities, for example is on fire while another, say blue-chip equities, has never looked cheaper, yet both share the same investment theme, ie rising oil prices? Answer: equity investors, sceptical about the long-term oil price remaining this high and in no mood for paying up for anything, hold back. The oil stocks end up lagging the story by a big margin and hence look like a great investment, especially on a risk/reward basis.
The differences between oil firms are less significant than the difference between where equity-market investors think the story should be priced compared to the commodity markets. Of course, the commodity markets could be wrong and oil might already be priced too richly. There's lots of evidence that financial speculation rather than real world demand and supply now drives much of the commodity complex. That doesn't mean the commodity story will necessarily be over anytime soon. Dotcom stocks looked ridiculously valued by early 1999 and yet the S&P didn't peak until the summer of 2000. Besides, who's to say commodity prices look ridiculously expensive yet? Recent industrial metal-price moves almost make oil and gold look like laggards.
Given that the safest bet remains that oil prices will continue to move higher, it seems irrational for equity markets to be pricing oil stocks as though oil prices will collapse again. Since higher oil prices will undoubtedly chip away at our standard of living as well, undervalued oil stocks present a doubly attractive opportunity; on the one hand to make money out of what appears to be a gross market inefficiency whilst on the other effectively providing compensation against the ravages of a higher oil tax'. Stocks to buy include BP (BP) and Royal Dutch Shell (RSDA) in the UK, Total (FP) and Repsol (YPF) on the continent, or Apache (APA) and Chevron (CVX) in the US.
James Ferguson is an economist and stockbroker at Pali International. He also runs his own premium share-tipping service, Model Investor.
The best oil stocks to buy
The oil price is primarily responsible for driving BP's profits. Since 2000, when BP last traded at this share price, oil prices have doubled from a 2000 high of $36 to $72 today. Operating profits (OP) have risen 63% since 2000, and given current oil prices, 2006 OP is likely to end up at about $36.5bn, pretty much double the 2000 figure. Holding the share price flat while profits double has driven the p/e down to 15-year lows yet the oil price keeps rising, as does the OP outlook. With bond yields so low, such a high earnings yield is simply unprecedented.
BP's three-year rally has just broken to a new all-time high for the first time in six years. This is all well and good for the chartist community, as it means BP is finally a blue-sky' stock, with no stake holders at higher levels to sell into rallies. However, it is the fundamental story that offers the huge upside and makes this look much more durable than a mere technical trading rally.
While BP may have just made a new high for the first time in half a dozen years, the oil price itself has literally doubled since then, from an October 2000 high of $36 to nigh on $72 today. Given the longevity of the trend, the lag to industrial metals' prices and the seasonal factors mentioned above, it seems reasonable to assume that oil will not only keep heading north for the time being, but could even spike up another $20 or so by the end of the summer, whereupon it would be two and a half times its peak 2000 price.
The oil majors
But even if oil might yet go a lot higher near-term, does that in fact matter to the major oil refiners? Although they explore for, and develop, oil fields, many argue that the terms of their contracts and their refining margins may well make their profits insensitive to the pure oil price or even worse, inversely correlated.
Actually, even though it may suit the oil majors to pretend to share the pain of higher oil costs, the evidence shows that US$ operating profits are a pretty pure function of the spot oil price. The average oil price last year was $56.59 and the average so far this year is $64.75, so, on a year-on-year basis, if oil prices were to rise no further this year, they'll still finish 2006 a full 24% higher than 2005.
This would suggest OP should grow by a similar amount, which is far ahead of the consensus of just 11.8% OP growth in 2006. However, in their defence, analysts have to use either the industry's, or their bank's, official in-house oil forecasts (both of which have substantially lagged oil all the way up).
The oil price is primarily responsible for driving profits. So far, since 2000, when BP last traded at this share price, operating profits have risen 63% and look set to rise a further 24% this year. If such growth is achieved (which hardly looks contentious at this stage, since it would seemingly require no further oil-price appreciation) then 2006 OP will end up at pretty much double the 2000 figure. The issue then is how can we reconcile an oil price that's doubled since 2000 and that may go higher near-term and a likely doubling in OP by year-end, with a share price essentially unchanged from 2000 highs? Mathematically, it can only be that the valuation multiple has collapsed both relatively and in an absolute sense.
BP's p/e has averaged about 17 times (ie, an earnings yield of around 6%) over the last 20 years and hasn't been this low for the last 15 years. Therefore, on an absolute basis, the stock is clearly deep into very good value country. However, the economic environment back in 1988-1990, when the p/e was last at this level, was completely different from today's. Inflation, and hence interest rates, were both much higher, so although the earnings yield was in the 8%-10% range, which should have been very attractive per se, ten-year gilts returned even more. Today, however, BP's 8%-9% earnings yield is double the 4.7% return available from gilts.
A reasonable argument is that BP is cheap compared to bonds because stocks in general are cheap compared to bonds, which does, incidentally, appear to be true. However, BP is also cheap compared to the average stock in the FTSE 100, especially compared to normal'. Big UK stocks in general have earnings yields of about 7.5% (13 times p/e), a significant discount to BP's 8.5% (12 times p/e). This is especially pertinent because for a long period up until 2000 (since when, as we've already established, BP has been mis-priced compared to oil and profits) the market required a lower earnings yield from BP than from the average stock.
There are of course a number of ways this could unwind. The most obvious risk' is that the commodities complex blows up and takes oil down with it. Since BP seems to be discounting oil at nearly half the price it is currently trading at, outside of short-term contagion, the share price downside even in this scenario would theoretically not be too severe.
One way to illustrate this is through the dividend payout ratio. BP could comfortably afford the current dividend even if earnings were to halve. In fact it could continue to pay out the same dividend if earnings dropped by two-thirds. Based on last year's profits, the dividend payout ratio is just 33% and our working hypothesis OP growth rate of 24% this year would lower that to 26%, less than half the long-run average payout and a new all-time low. With a dividend yield of 2.9% but a payout ratio heading towards half the long-term average, dividends will be under increasing pressure to rise and possibly even double.
Obviously a dividend yield of 5.8% would be eye-catching stuff, but in fact even the current dividend should alone justify a share price trading significantly higher. Over the last 20 years, BP's dividend yield has usually been about half the long gilt yield. which would make the appropriate yield today about 2.35%, suggesting a share price at least 25% higher. But what if oil company dividends aren't raised? Then these huge cash flows would be pumped back into the companies, forcing share buybacks or vastly increased exploration and research and development spend, boosting long-run earnings potential. In a low interest rate environment, a rational and efficient market pays a much higher price today for future earnings than when discount rates are higher. Again, the stocks should go up significantly to price that in.
The risk of windfall taxes
Another perennial bugbear when things are good in the oil industry is the spectre of windfall taxes raising its head. There are two significant problems for the government in this regard. The first is that to be in any way fair or consistent, windfall taxes when things are good would have to come with some sort of windfall subsidy in the event of lower oil prices a political no-no. Just taking any upside gains would be tantamount to nationalisation and that would just drive these companies off-shore and do inestimable damage to the City's reputation as an international finance centre. Besides, government wouldn't even want the debate to get started. At the moment it can deflect the public's oil price fury at the oil companies but the truth is that taxes on oil already dwarf the share retained by shareholders.
About 75% of the pump price paid in the UK is to the Chancellor in the form of excise duty and VAT but it doesn't stop there. Corporation and petroleum revenue taxes can then halve the amount of operating profit that is actually available to shareholders and we haven't even included NI and taxes on staff wages yet, which for big employers like Centrica can also exceed the shareholders' take. Advice to government: don't go there.
Since 2000, the oil price has doubled, oil firms like BP's profits have doubled whilst alternative assets' returns (such as gilts') have halved. Yet BP is still the same price as it was six years ago. This appears to be an unprecedented value opportunity, made all the more pressing in the case of BP by a share price chart that has just broken to a new high and an oil price that shows no sign of having lost its upward momentum. Note that this story runs sector-wide. Royal Dutch Shell (RDSB), for example, which I recommended at the last MoneyWeek Roundtable that I attended, has an even lower 10x p/e (an even higher 10% earnings yield) and is still trading at a 12% discount to its 2000 highs; yet Shell shares all the same gearing to oil prices (2005 OP was 62% higher than 2000, compared to BP's which was 64% higher) and has a higher 3.2% dividend yield (versus 2.9% for BP).
And the same story holds abroad too. In Europe Repsol (YPF) and Total (FP) look especially cheap, whilst in the US, apart from Exxon Mobil, both Apache (APA) and Chevron (CVX) look great value too. We may get hit by higher fuel bills this year, we are already paying more at the pump and a slowing economy may well hit confidence and job prospects in the months ahead. But at least we can do something to fight back. If oil prices end up at these levels or go higher, shares in the oil majors should do really well to catch up. If oil prices come off again, well, the oil stocks appear to be discounting such a low oil price that the downside threat should be minimal, especially given the decent 3% dividend yields and three to four times dividend cover.
Join more than 165,000 subscribers and keep yourself informed with the latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.