Oil Stocks Hit Bargain Bin

Paradox: Despite the sharp rise in oil prices, bargains are bubbling in major oil stocks.

The stock price of major oil companies hasn’t kept pace with the price of a barrel of oil, which is now 95% more expensive than 12 months ago. Investors are skeptical that majors such as Exxon Mobil Corp. and Royal Dutch Shell PLC, which do everything from drilling oil to refining it to selling it, are going to have big futures. The stocks are actually down this year.

Analysts make a case for buying major oil-company stocks for the short- to medium-term. One reason is that these stocks are trading at low price-to-earnings ratios, relative to the market and historically.

Also, should oil prices move lower, these stocks tend to hold up decently. That is what happened in the 1980s when crude prices fell with a vengeance after the previous decade’s spike, a pattern many expect to recur eventually.

But for the long term, the outlook for these stocks isn’t rosy, as they face their biggest challenge ever: lack of oil-production growth or even a decline in output. Signs of this have emerged in the earnings statements of recent quarters, making some observers think these companies may not even be around in 10 to 15 years.

A good proxy for what is happening to the oil majors is Exxon, the world’s largest oil company by market capitalization. Shares shed 58 cents to close at $85.48 Friday in New York. It is now trading at a P/E of 11 based on trailing earnings, versus 21 for the Standard & Poor’s 500-stock index. By contrast, more-specialized SchlumbergerLtd., which provides oil-field services such as drilling, is trading at a P/E of nearly 23.

Exxon’s P/E has been in the range of 10 to 13 since 2004, its lowest level since the last time oil prices rose, in the late 1980s and early 1990s, with the onset of the first Persian Gulf War. Oil rose from about $17 a barrel at the start of 1989 to $28 by the end of 1990.

Today, “the majors, on the whole, look pretty cheap,” says Justin Perucki, an energy analyst at research firm Morningstar Inc., who assumes a long-term price of oil at $85 to $95 a barrel for valuing these companies.

This pricing situation isn’t a new phenomenon. Exxon and the oil majors have historically gotten less expensive when oil prices have shot up. In 1973-74, when oil prices rose because of an oil embargo from the Middle East, Exxon’s earnings per share doubled, but the P/E came down from about 13 to five. Again in 1979-1980, when oil spiked because of the revolution in Iran, Exxon’s per-share earnings doubled, but its stock price didn’t rise as much, so the P/E fell.

Charles Maxwell, a senior analyst at Weeden & Co. who has been tracking oil stocks since 1968, says this happened because the market realized that the oil-price rises were only temporary and didn’t bid up its stock price too much.

This time, once more, investors are skeptical that oil can stay at current levels: Prices may not fall below $100 a barrel but won’t stay above $140, the consensus runs. That belief has led to the discounting in major oil stocks. Exxon’s earnings per share have gone up 380% from 2003 until the end of June, but the stock price is up only 150% during this period. The P/E has come down, from about the low 20s to 11 more recently.

The large oil companies are hobbled by their diversity. While the majors’ main business of oil production benefits from higher prices, their refining units, which consume crude oil to produce gasoline, suffer declining margins because they can’t pass higher costs on to consumers fast enough.

The good news is that, if crude prices drop, the majors don’t suffer unduly. “Given that they haven’t benefited [a lot] from the run-up in oil, you’d expect some of those names to be more defensive when oil retracts,” says Michael Hulme, a global oil-stock analyst at MFS Investment Management.

Over the long pull, however, these companies don’t offer much to get excited about.

For the major companies, production growth, especially in their American fields, has either stalled or declined in the past several quarters. Many of the fields these companies started drilling decades ago have matured. “You just can’t expect them to be huge growers,” says Tim Parker, an analyst at money-management firm T. Rowe Price, which owns Exxon shares.

Life has gotten tougher for the majors in their foreign endeavors. Decades ago, these companies were welcomed for their huge funding and technological and engineering prowess. Today, these companies are facing increasing nationalism in countries such as Venezuela, which are reducing the amount of oil they are willing to give up to let companies such as Exxon come in and drill. Now the oil-producing countries are flush with cash, and have either developed their own expertise or simply outsourced the drilling to service providers such as Schlumberger and Halliburton Co.

“What is it that the big oil companies bring to the table now? Not very much,” says Mr. Maxwell of Weeden.

The 76-year-old Mr. Maxwell, who was ranked among the top oil analysts in the 1970s and ’80s, believes that it won’t be too long before these companies become takeover targets. “They can be broken up and put into other companies and would have greater value in the stock market,” he says.

Write to Shefali Anand at [email protected]