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Industry Analysis: Petroleum (Producing)
Value Line's Petroleum (Producing) industry consists of companies that explore for and produce oil and natural gas, primarily in the United States, with most of their projects being land-based. Our grouping predominantly consists of mature companies, although there are a few growth vehicles. The profits and, consequently, stock prices of petroleum producers depend on internal and external factors, as discussed below.
First and foremost, the performance of companies in this industry is dictated by the prevailing price of oil and gas. In turn, these prices depend on demand, which is influenced by economic health and activity. Only if a company can sell oil or gas at a price above extraction costs, can a profit be made.
Geopolitical risk is another factor. Most of the companies in this industry aren't affected by this risk, since they operate in the U.S. Those entities exposed to foreign government intervention, public unrest and/or insurgency are vulnerable to having their holdings confiscated, disrupted, destroyed, regulated or limited in their drilling activity.
A driller's geological prospects are another external element. It's important to know how well a company can locate oil and gas reserves, how much is potentially recoverable and at what cost they can be extracted.
Reserves are highly significant. Companies must know how much raw fuel is in the ground to produce. This figure can and does vary tremendously. The quality of the buried commodity is also a key factor. Before extraction, refining costs for particular end-uses should be determined.
Production is one other major internal variable. Daily production goals need to be set and met. A producer has to have agile enough operations to quickly and easily change its output rate when oil and gas prices change.
Another influence is proximity to ultimate markets. How close an oil or gas field is to a large urban area, with high demand, is important. A good example of this is the extensive presence of two large independent producers in the Appalachian Basin's Marcellus shale fields, which are near the heavily populated northeastern states.
Infrastructure is another noteworthy consideration. If refining capacity and pipelines are not readily available to process and transport a raw commodity from the point of origin, they have to be built at huge cost. This is why so many companies drill in the Gulf of Mexico. Despite the climatological and geological hazards, it is much easier to deliver crude oil and natural gas by water-borne tankers than by land transportation.
A company's balance sheet is also important to review. Investors should be aware of a producer's financial strengths, any capital constraints, and how much funding is available for planned drilling projects. More and more, these days, managements are hedging operations with ample up-front capital for use when needed.
Investors also need to know managements' primary focus. Earning a high near-term return on investment may be the priority, or the strategy could be to invest for long-term rewards. The risk/reward position needs to be defined. Some companies will emphasize 'wildcatting' (i.e., drilling ad hoc and hoping for a big discovery), and others will drill conservatively (with a number of holes around a known reserve).
Costs and expenses are obviously important, and they may be classified as both internal and external. As the pace of drilling picks up, on higher demand, operating costs will climb noticeably. Unconventional gas-well sites around shale, tight gas and coal-bed methane formations, for example, require extra drilling and stimulation technology to maximize flow rates, which lifts spending. Too, when the prices of acquisitions rise, funding expense and depreciation & depletion charges can increase-a consideration for nearly all the companies in the industry.
So, what kind of investor would be interested in this industry? Well, certainly not an income-oriented one, since the dividends paid, if at all, are meager due to the capital-intensive nature of this industry. Those attracted to this industry are investors looking for a cyclical play, which could last for as little as a few months, or as much as a few years.
How should one value these stocks? Not on a conventional Price/Earnings basis, since this industry's ratio is always well below market averages due to the high volatility of oil and gas prices. Price/Cash Flow is more useful, since depreciation and amortization expenses are more stable than earnings. Mature companies generally have a P/CF of 5 to 6, whereas growth entities sell at a multiple of 7 or greater. Price/Asset Value is another useful measure. If the pretax present value of reserves is greater than its market cap, a company will risk drilling in unproven areas. If this is not the case, such activity probably won't occur.
Generally, as soon as investors see the demand trend for energy increasing, or decreasing, they buy up, or sell off, the stocks in this industry. P/Es usually expand during soft earnings periods and contract when profitability improves. Another effect, lying just below the surface, is the industry's ability to effectively control production (and refining) capacity. A situation of over-supply can drive down fuel prices and net profits. Reasonably tight capacity has the more favorable, opposite effect.