War's effect on oil prices, stocks uncertain

www.kansascity.com Posted on Sun, Mar. 09, 2003 By KEN BROWN and THADDEUS HERRICK The Wall Street Journal

In a stock market starved for earnings growth, you would think investors would love an industry that is minting money now and could be flush with profits by year's end.

But shares of oil companies were down during the past six months, even as prices have soared on war fears and the strike in Venezuela.

Since its recent low in November, oil is up nearly 50 percent, yet the stocks of oil companies are up about 1 percent, slightly ahead of the overall market, which is flat for that time period. April contracts on U.S. light, sweet crude reached a post-Gulf War high Feb. 27 in New York, settling at $39.99 a barrel.

Investors, in effect, have refused to give the oil companies any credit for higher oil prices. The reason is simple: The last time there was a war in Iraq, oil prices collapsed minutes after the first bombs started to drop, from a peak of $40 a barrel in 1990 to under $20.

The conventional wisdom goes something like this: The United States attacks Iraq, oil prices collapse, the stock market soars and oil stocks lag far behind. No wonder investors have been ignoring the big earnings gains of companies such as BP PLC, ChevronTexaco Corp. and Exxon Mobil Corp.

The problem is, in the fog of war and the fog of the stock market, few scenarios play out exactly as expected.

For instance, conventional wisdom did not anticipate the stock market rally that started once the Persian Gulf War commenced in 1991. Moreover, a growing number of investors and analysts are saying that oil prices may stay higher than expected this year and oil stocks may be more attractive than people believe.

Indeed, the basic assumption of the current conventional wisdom -- that a war in the region will make oil more plentiful and therefore cheaper -- is questionable. Other wars in the Middle East, including the Iran-Iraq war and the conflicts between Israel and its neighbors, all have hurt supply and driven up oil prices, sometimes by huge amounts.

"I think the conventional wisdom is because this is what happened in the Gulf War, as soon as the first shot is fired, you run for the hills," said T. Rowe Price energy analyst Tim Parker, referring to investors selling oil and oil stocks. "But what people forget is, the war before that (Iran-Iraq), when the shooting started, (oil) did the opposite. It went to the moon."

The weak stock prices of oil companies show that even if many investors doubt the consensus view, they aren't buying.

Why? Because even if they believe oil stocks will be higher six months from now, they think the shares will get cheaper when the war starts, and they would rather wait until the stocks touch bottom before laying out money.

"We'll be clamoring down there for that good price and the good price will disappear," Parker says. "I just feel like sometimes we get a little too cute with ourselves."

Investor sentiment is also lagging behind government data.

The Energy Department's Energy Information Administration says low global inventories and dwindling spare-production capacity will keep prices above $30 this year. But an informal poll of 25 money managers based in Boston done by research firm International Strategy and Investment put the price at $27 a barrel at year's end. A mid-January poll by information company Reuters of oil analysts and consultants put the average price of oil at $22.81 this year.

What is clear is that at $30 a barrel or so, oil company earnings will be solid. "Oil companies are in fat city," said Fred Leuffer, a Bear Stearns oil industry analyst. "They're going to coin so much money in the first quarter, I don't think any of us analysts can go higher."

Leuffer, who remains generally bearish on oil and oil stocks, raised his oil price estimate from $18 a barrel to $22 and boosted his 2003 earnings estimates for ChevronTexaco 18 percent to $5.90 and ConocoPhillips by 20 percent to $5.10. He more than doubled his estimate for exploration-and-production firm Kerr-McGee Corp. to $3.75. But, he added, "The market doesn't pay for short-term windfall profits."

Oil averaged $25.03 a barrel in 2002 and $24.86 in 2001. Oil bulls give several reasons why prices can top that this year.

First, commercial inventories are considerably lower than they were in 1991. The International Energy Agency, a watchdog for oil-consuming nations, says stocks of crude oil and refined products are 2.1 percent lower than at the end of 1990, having fallen to 2.541 billion barrels from 2.611 billion barrels more than a decade ago. In the United States, the world's largest oil consumer, crude oil stocks are 12 percent below the five-year seasonal average and 16 percent below year-ago levels.

In addition, analysts don't expect Venezuela to get back to full production anytime soon following the strike there. And demand, driven in part by the cold winter and sport-utility vehicles, has stayed strong. The latest report from the Energy Information Administration showed that demand for petroleum products in the four-week period ended Feb. 21 is up 3.7 percent over the year-earlier period. Demand for distillate, which includes heating oil and diesel fuel, is up 20.9 percent.

"This is the biggest gas-guzzling economic slowdown I've ever seen," said analyst Phil Flynn of Alaron Trading Corp.

Persistently high oil prices could have broad implications for the stock market and the economy. Economists, including the director of energy economics at the Federal Reserve Bank of Dallas, say high oil prices could push the economy's sluggish growth rate toward zero this quarter.

In addition, the costs weigh on consumer spending and corporate earnings. For consumers, spending more on gasoline, electricity and heating oil means less money for wide-screen televisions, vacations and cappuccinos. "Energy prices go up, the consumer chokes and boom we go right back into recession," said Merrill Lynch equity strategist Richard Bernstein.

For the stock market it means the majority of companies earn less, some a lot less, because of energy costs. That could push stocks down.

But it also means oil companies earn more, some a lot more. Analysts say most major oil companies are priced for oil between $22 and $25 a barrel. So if oil prices stick anywhere above $28 a barrel, earnings will soar, either pushing the stocks up or leaving them very cheap.

Bear Stearns' Leuffer calculated that oil exploration and production companies such as Kerr-McGee, Amerada Hess Corp. and Occidental Petroleum Corp. would get the biggest boost to their earnings from rising oil prices. Among the major oil companies, ConocoPhillips, ChevronTexaco, and BP would see their earnings rise the most.

If oil prices fall from their lofty heights but stay relatively high, the biggest beneficiaries could be the oil refiners, companies such as Tesoro Petroleum Corp. and Valero Energy Corp. These companies' earnings would rise as margins increase because the cost of oil would fall faster than the price they get for gasoline and other refined products.

The problem is, investors know this and have driven up shares of the refiners by more than 20 percent since they bottomed in October, well ahead of both the market and the big integrated oil producers.