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Published On: Sat, Oct 23rd, 2010

Analysis and Comments

Like all other sectors of the economy, any recession in world economy and fluctuations in prices of crude oil may have an adverse effect on the entire sector. Further, the sector being highly regulated is always susceptible to changes in environmental regulations which increase compliance thereby affecting the profitability. The smaller players in the sector, whether upstream or downstream, have to battle bigger entities possessing economies of scale and forward / backward integration. However, clear price trends in respect of crude oil, natural gas, products like gasoline & diesel augur well for both upstream & downstream companies. Obviously, there are differences between the risk factors associated with the two categories of companies.

UPSTREAM

Huge requirement for Capital expenditure and also the uncertainty associated with the probability & possibility of finding economically exploitable reserves makes one cautious of the future of specific upstream companies.  The high profit margins of exploration companies may appear attractive, but relatively higher uncertainty in future cash flows makes them fraught with higher business risk. Of course, better technology may increase the accuracy of predictions but serious errors in estimation of availability of reserves have been known to happen.

DOWNSTREAM

In case of refining and marketing companies, the net profit margins are extremely low. The capital expenditure is mainly on building better refining capacity or increasing presence through stores / stations, maintenance of infrastructure, building delivery pipelines etc.  Increased energy efficiency of transport vehicles & lower energy prices in future may dampen the speed of growth in demand but, as part of the evolution and R&D process, creation of better and more economical products can be expected. Pricing power of the companies is limited due to extremely high level of competition and the relatively less number of opportunities for differentiation in the products. However, improvements in efficiency in refining and logistics can help maintain the profits margin over the long term.

PICKING THE CHERRY

Thus, perhaps, like all sectors having demand growth potential, it ultimately boils down to proper stock selection. Amongst the three stocks elaborated above, the choice will depend on the risk appetite and expectations. If one compares WLL (Jan 11 close – $47.55) & KOG (Jan 11 close – $9.20) on the parameters mentioned in the table below, WLL appears to be an obvious choice due to its lower valuation and debt / equity ratio. Size of the company also does matter as it provides a better sense of security and higher expected future cash flow (PV10% $7.4B vs $660M for KOG). The acreage and reserves for WLL mentioned in the discussions above (due to its size of operations) also tilt the scales for choosing the stock. The capex being planned by the company is also manageable if the current net income figures are considered. For KOG, the capex planned appears to be asymmetrical compared with its financials increasing business risk. The PEG for KOG (0.41), however, is lower than that for WLL (1.0) indicating better growth prospects. This could be due to the extrapolation of recent exponential growth achieved by KOG. The smart money also prefers WLL as institutional holding in the stock is significantly higher. The ROE for WLL is also significantly higher compared with KOG.(Source: Yahoo finance)

Comparison of parameters

oil and gas stocks

Source: Yahoo finance

The charts are, however, stronger for KOG with the golden cross having been achieved recently. The average 10 day volume (5.4M) is higher than the 3 month volume (4.2M) indicating increased recent interest in KOG. For investors of course, the fundamentals should matter and the WLL stock can be bought with a long term horizon.

Regarding TSO (Jan 11 close – $42.17), the stock is reasonably placed in the refining / marketing segment with lower P/E, higher NPM and lower D/E ratio as compared with other players like Valero Energy Corporation (NYSE:VLO).  TSO has higher current ratio as compared with VLO. The price to book ratio is also lower as compared with most of its peers.

 

oil and gas stocks 2

Source: Google Finance

The recent expansion of plans of TSO for increasing its outlets also gives confidence that the growth story of the company is likely to be continued.

Technically, the stock is looking extremely strong with the current market price being much higher the short term averages. The fact that the golden cross has held for months shows the strength of the stock. Smart money has significant holding with institutional stake being in excess of 90%. (Source: Yahoo Finance)

(A word of caution, all the three stocks have risen substantially during the past few months and hence possibility of a correction, especially after the upcoming results, cannot be ruled out).

 

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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