Big Oil: Boom or Bubble?

Today, the Senate Judiciary Committee called a meeting with executives from the biggest oil companies – Exxon Mobil (XOM), ConocoPhilips (COP), Shell (RDSA.L), Chevron (CVX), and BP America (BP) – demanding to know why gas prices are so high. Most of the executives cited the laws of supply and demand. As long as people continue to consume oil faster than it is being produced and bought in the US, prices will continue to rise.

Furthermore, oil prices set a new record above $134 today when the Energy Department’s Energy Information Administration reported that crude inventories fell by more than 5 million barrels last week, even though analysts had expected a modest increase.

The Boom

The five largest US and British oil companies together only account for 11% of worldwide output. The bulk of the world’s current and future production comes from the Middle East, and possibly recent discoveries such as those in Brazil. The American oil companies are not dictating the price of oil; the global market is. It just happens to be their turn to profit.

Global Supply and Demand

China is the world’s second-biggest oil consumer after the U.S., and is the world’s fastest-growing oil consumer. However, whether or not China is really consuming all the oil it is buying and producing is anyone’s guess. China does not report consumption, thus analysts guess this number from production, trade, and inventory data that may not have been accurately reported.

In terms of supply, the 13 nations in OPEC are unreliable in their output reports and may be producing above their quotas in hopes of being allowed bigger quotas.

The Bubble

Because worldwide supply and demand numbers are so vague, much of oil price direction is controlled by speculation. Every time the Energy Department reports a drop in crude inventory, the oil market rallies, driving crude oil prices up to a new record. In a very disproportionate way, oil prices are still following the laws of supply and demand.

The Reality

According to Larry Chorn, chief economist of the energy information unit of The McGraw-Hill Companies [1], even the most expensive wells in the world today can produce oil for $70 to $80 a barrel, which includes the cost of finding and developing the oil fields and a 12-15% profit margin. However, the big oil companies (outside of OPEC) are already producing oil at their maximum rate.

Two decades ago, when oil prices were low and profit margins were slim, big oil companies merged, cut capital spending, and sold off thousands of wells. These large companies seemed to still be stuck in this mindset even as oil prices rose in the last few years, and until recently were hoarding their profits instead of increasing spending to invest in new exploration and drilling.

The Future

It can take over a decade to bring a new oil field online, and the big oil companies are behind. Last year, oil production from the top five oil companies fell 3%. As long as supply and demand numbers remain unknowns, the market will have to rely on speculators to bring oil prices back down. This will likely only happen if local inventories increase. With Big Oil output steadily falling, smaller companies will need to step up to account for the deficit. Last year, the publicly traded energy companies excluding the big five increased their oil production by 16%.

To put numbers in perspective, crude oil imports have averaged 9.86 million barrels a day this year. US crude oil production has averaged 5.10 million barrels a day. Average crude oil consumption in the US has been 20.69 million barrels a day. [2]

While the big oil companies will continue to enjoy inflated profits for some time, the true winners in the next few monhts will be the smaller companies that have invested heavily in production and are just beginning to ramp up their output.

Some of my favorite small oil companies include:

W&T Offshore, Inc. (WTI)

Occidental Petroleum Corporation (OXY)

Anadarko Petroleum Corporation (APC)

Noble Energy, Inc. (NBL)

1. http://www.businessweek.com/
2. http://www.eia.doe.gov/neic/quickfacts/quickoil.html

Forget Share Price, Percentage Gain is All That Matters

Some investors are very hesitant when it comes to buying cheap stocks under $10, and some investors are hesitant when it comes to buying expensive stocks that are over $100. Investors need to get out of the mindset of how much a stock cost, but instead think about the percentage gain they can make from a company or the future outlook of a particular company, regardless of its price. If you buy a $10 stock, selling at $11 is a 10% gain. If you buy a $100 stock, selling at $110 produces a 10% gain. It doesn’t matter how many shares you can buy of a company, but only the percentage gain you can attain from purchasing any given amount of shares of a company. Producing a 25% gain for your entire portfolio during any given year would be wonderful, and it shouldn’t matter how much you paid per share.

Consider the two following stock purchasing scenarios with an original investment of $2000:

1) Buy 4 shares of Google (GOOG) at $500 and attain a 20% gain by selling at $600
2) Buy 100 shares of Aeropostale (ARO) at $20 and attain a 20% gain by selling at $24

Regardless of the two scenarios just mentioned, a 20% gain and a $400 gain has been achieved. Doesn’t matter if you have an odd lot amount of shares or an even 100 shares or how much the original share price is. The 20% gain is all that matters.

Stocks with a market capitalization (outstanding shares times stock share price) under a billion dollars are considered small cap companies that usually have the best possibility to be growth stocks. Companies with over 10 billion dollars in market cap are labeled as large cap companies, and much of their primary growth phase has generally passed. It is more difficult to sustain such a large level of growth when the company is already so big. On the other hand, some examples of large cap companies in recent years that have shown much growth despite their worldwide presence are companies like McDonalds (increased 65% since the middle of 2005) or Chevron (increased 45% since the middle of 2006). McDonalds (MCD) and Chevron (CVX) represent markets caps of 58 and 157 billion respectively with dividends above 2%.

Even though I stated that small cap companies have the opportunities for the largest amount of growth, they are also more susceptible to volatility if they don’t grow as fast as investors anticipate. They will generally fall faster than large cap companies in bear markets because they won’t have as much cash flow as large companies and will probably have a higher debt-to-equity ratio. When earnings come out for these high-growth small cap companies, investors will look for earning to exceed expectations. Even just meeting expectations may not be good enough to propel the stock higher.