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What to do when oil stocks can’t keep up with oil prices

This U.S. advisory tells us why oil stocks lag behind oil prices and what happens next. It also sees bullish signals in the stock market.

It’s easy to be mesmerized by oil and gas. They fuel our vehicles and heat our homes, and the rise and fall of energy prices is front-page news more often than not. Apparently, we can’t get enough of it.

Yesterday, we heard from a leading Canadian advisory that explained why rising energy prices have been so beneficial to the leading oil and gas royalty trusts.

Today we get a less optimistic point of view. U.S. oil stocks, says Dow Theory Forecasts, are lagging behind oil prices. And some of the biggest companies are the biggest laggards.

The advisory presents four reasons for this disparity and gives us the outlook on its favourite energy stocks in the face of this price-to-performance gap.

But first we’ll pause to consider an interesting piece of news from this advisory — the market is looking bullish.

Transports go bullish

This advisory is the inheritor of Mr. Charles Dow, the original market theorist. And here’s what its benchmarks are saying:

“The Dow Industrials closed above 12,743.19, confirming a move to significant highs in the Dow Transports and returning the Dow Theory to the bullish camp.” Known as the Rail Index back when Mr. Dow first developed his theories, the Dow Jones Transportation Index serves as a key indicator of moves in the stock market.

Based on this movement, the advisory has reduced its recommended cash position to 15 to 20 per cent, with an eye to reducing it further as more opportunities in stocks arise.

“A bull-market signal does not mean stocks will rally higher without interruption, and near-term moves in both directions are likely as more earnings are released,” says the advisory. “But, with the Dow Theory’s return to the bullish camp, a more constructive stance toward stocks is appropriate.”

But what about those foot-dragging oil stocks?

Deep water and Catch-22

The price of oil jumped almost 70 per cent since August, points out the advisory (although it has slipped back since this report was issued at the beginning of the week). Natural gas prices have rallied more than 80 per cent. But energy stocks have not kept up.

The S&P Energy Sector Index is up 20 per cent since August, a far cry from 70 per cent. Only independent exploration and coal companies have matched gains with commodity prices.

The big energy firms have four problems. The first is replacing reserves. The nationalization of overseas oil fields has put a crimp in big oil’s search for more reserves. What’s more, the need to explore deeper water runs up exploration costs.

Then there’s a sort of Catch-22. For many big integrated firms, it’s not a simple matter to translate high per-barrel prices into improved profits. Because as oil prices go up so does the cost of the energy needed to run their refining and chemical businesses!

Next is Wall Street’s fixation on the future. The Street is anticipating a more subdued economy, and therefore a drop in oil demand, a lowering of prices and reduced demand for oilfield supplies and services. So even if oil prices go up, nervousness about oil stocks prevails.

Finally, the margins for refining aren’t great for the integrated companies. The S&P 1500 Integrated Oil & Gas Industry Index is up a mere 12 per cent since August and flat so far this year. The refining index is down 28 per cent so far this year. So much for doing it all yourself.

Restoring lost production

This does not mean investors should give up on the big oil companies, says the advisory. They may not be meeting expectations, but they’re still making a heck of a lot of money.

There are opportunities to be had with select oil stocks. Among the big producers, Chevron Texaco (NYSE-CVX) and Exxon Mobil (NYSE-XOM) are the advisory’s favourites.

Of the two, the advisory highlights Exxon. Its shares fell after the company said capital expenditure for 2008 would go up 25 per cent while production would fall slightly.

“Yet there are reasons to think Exxon will benefit from the high price of oil. So far this year, the shares of Exxon are up 1%, one of the better performances among the oil super-majors,” explains the advisory.

Exxon’s oil and gas reserves fell 3 per cent last year, and production fell 1 per cent. But Exxon replaced 130 per cent of its reserves from 2004 to 2006, and should regain some of that lost ground with a dozen production startups this year and nine next year. The advisory makes it a long term buy.

“While declines in oil and natural gas prices over the next year would not be a surprise,” says the advisory, it expects prices to remain well above historical norms, “high enough to support strong drilling activity.”

Remotely operated plungers

Dow Theory Forecasts is particularly bullish on oilfield services companies, in particular National Oilwell Varco (NYSE-NOV), Oceaneering International (NYSE-OII) and Transocean (NYSE-RIG). Oceaneering is highlighted in this article.

It is expected that the amount of oil produced by deepwater oil fields will have doubled from 2005 to 2010 as energy producers move farther and farther from shore. Deepwater spending could reach $25 billion by 2012, twice the level of 2003.

Oceaneering’s biggest asset in this deepwater plunge is its remotely-operated vehicles. Its 210 underwater vessels command rental rates of $8,750 a day, and that’s 16 per cent higher than last year.

The company’s share price pulled back from October highs and it now trades at a reasonable 19 times expected 2008 earnings. When this report was issued, Oceaneering’s latest earnings report was still awaited. It was released on Wednesday and showed record first quarter earnings, with a 25 per cent year-over-year gain. The advisory makes this stock a Focus List Buy, i.e., a best buy for the next 12 months.

Why do rising oil prices always drive up prices at the pump, but not necessarily the share prices of the energy stocks we own? Be patient, says this advisory. If you’ve picked the right stocks, they too will rise.