Trade in Groups

Since the beginning of 2007, the long crude trade has been extremely profitable, as barrels of light sweet crude have risen nearly 150%. The rising costs of energy and other commodities, when combined with declining home prices and tighter lending standards, have resulted in worries about the strength of consumer spending. These fears have translated to almost all consumer discretionary stocks being hit, in addition to fuel-sensitive industries such as transportation.

While the broad-based effects of pricier oil make it tempting to place bets – long or short - in a number of areas, there is no reason to speculate on areas tangentially related to crude prices unless you have a stronger, more focused thesis about those stocks. Why do I say this? While most of the attention about where to make money in the energy complex is on the energy service companies – think Schlumberger (SLB) – looking at what’s on the books of the major E&P companies suggests they are extremely cheap in a world of expensive oil.

ConocoPhillips (COP) has consistently traded at a discounted earnings multiple to names like Exxon Mobil (XOM). With a $165 billion market cap and 10.779 billion proven barrels of oil equivalent (a metric to equalize oil and natural gas) at 2007 year end, Conoco’s reserves are valued at slightly over $15/barrel. Even with $22/barrel in production costs excluding income tax, there is still a substantial profit margin to be made on that crude in the ground – and half of that $22/barrel is non-cash charges related to depreciation and depletion.

So what does it cost Conoco to bring new capacity online? Conoco’s 2007 E&P CapEx was $9.57 billion, and it resulted in about 300 million barrels of oil equivalents, for a cost of slightly more than $30/barrel. With its retained capital, Conoco - as well as other oil companies - have the choice to reinvest in expanded production, or buy back their own stock. The cost discrepancy between buying back their own reserves (valued at $15/barrel by the market) and reinvesting in production (at a cost of >$30/barrel) shows why Conoco spent almost as much on share repurchases - $7 billion – as it did on E&P. The oil companies themselves are quietly saying their assets are undervalued; keep in mind the $15/barrel price excludes all of Conoco’s other assets. I guarantee running a similar analysis with other oil majors will yield equally interesting results.

So why do I prefer the E&P majors over the oil services companies? Valuation is a part of it, but given that substantially more shareholder value is created through share buybacks as opposed to reinvestment (i.e., where the services companies make their money), E&P isn’t going to be the first capital spending priority of the oil majors, especially considering that E&P costs per barrel continue rising, while the stagnant market values of the oil majors have resulted in value compression in favor of buybacks. Consider the chart below, which shows the ratio of an E&P ETF (ticker: PXE) against the Oil Services HOLDRs (OIH).

Despite the rapid increase in the value of the oil major’s assets-in-ground over the last year, those companies haven’t outperformed the oil services companies. As crude has soared lately, however, PXE has started to gain momentum against OIH, and a breakout above the 0.1475 point could be imminent.