Week 183 - Buffett Buy Analysis of Oil and Natural Gas Companies

Situation: Oil and natural gas companies account for 8% of US GDP. Their stock prices mainly reflect 3 factors: 1) the pricing of front-month futures contracts, 2) the amount of proven and economically recoverable reserves in the ground, and 3) the expected rate of growth in the world’s appetite for oil. All of those numbers will fall if there is a recession in one of the world’s major economies. Europe is now on the brink of entering its third recession in 10 yrs (triggered by the crisis in Ukraine), which is one reason why the price of oil fell 40% between June and December. But there are two other reasons to consider. 

The US is becoming the dominant oil and gas producing country by rapidly exploiting the twin technologies of hydrofracking and horizontal drilling. This is now causing a price war with the about-to-be-eclipsed countries (Russia and Saudi Arabia). Their strategy is to continue maximal production with traditional technology, which is cheaper than hydrofracking. That means their oil and gas has a lower price point (for making a profit) than US oil and gas. We’ll see who wins, but in the meantime the US consumer gets to have a better Christmas!

The remaining reason why the price of oil is falling is that vehicles are getting better fuel economy. And, $4.00/gal gasoline has changed people’s driving habits, e.g. fuel economy is now the most important consideration when buying a car. More importantly (for the long term), natural gas is starting to replace gasoline and diesel fuel in commercial and municipal vehicles, and even in locomotives and jet fighters. The revolution doesn’t end there, because electric motors will likely power most highway vehicles by 2050, given the current pace of research into battery development. Natural gas will remain an important feedstock for electrical power plants but there will be little need for oil other than as a lubricant and a source of asphalt.

Caveat Emptor: The “story” that supports the prices of energy stocks is always in flux, as well as being complex.

Given that oil and natural gas companies will increasingly emphasize natural gas production over oil production, is this a good time to invest in these suddenly cheap companies? By now, of course, you realize this would be more of a gamble than prudently investing for retirement. Normally, one makes this decision by estimating future earnings (or cash flows), then applying the growth rate for that industry to discount earnings back to the present. That gives an estimate for Present Value for the stock (i.e., what the current price should be). That Discounted Cash Flow (DCF) method has never worked very well for volatile (cyclical) stocks. Those are the ones that track the ups and downs of the economy too closely, such as oil and gas “exploration and production” stocks. 

Instead, let’s use our old standby of the Buffett Buy Analysis (BBA). It simplifies the DCF method by projecting the trend-line for the past decade’s growth in core earnings (as calculated by S&P) to the end of the next decade (see Week 30, Week 94 and Week 135). That number is then multiplied by the worst P/E seen in the past decade. Mr. Buffett adds on the value of its current annual dividend multiplied by 10, since he doesn’t assume the company will be growing its dividend. Voila! He has a price prediction for 10 yrs from now and can calculate the BBA, which is total return/yr over the next 10 yrs (see Column T in the Table).

How has that worked out for him buying oil and natural gas stocks? He bought 18 million shares of ConocoPhillips (COP) early in 2006 for Berkshire Hathaway but soon thereafter decided he’d bet on the wrong horse. Now he’s down to 1.4 million shares of COP and 6.5 million shares of Phillips 66 (the recent spin-off of ConocoPhillips’ refinery operations). With the proceeds from those sales, he bought 41 million shares of ExxonMobil (XOM) and 7.3 million shares of National Oilwell Varco (NOV). In other words, he changed his mind when the Great Recession exposed the underlying value of specific energy companies (see Table).

The Buffett Buy Analysis starts by determining whether the company has a Durable Competitive Advantage (DCA). Mr. Buffett defines a DCA as a decade’s worth of steady growth in Tangible Book Value (TBV) at a rate of at least 9%/yr, with no more than two down years (see Column S in the Table). We’ve used his method to analyze the 40 oil and natural gas stocks in the Barrons 500 List of the largest US and Canadian companies. After excluding companies that don’t have the required DCA, plus an S&P investment-grade bond rating (i.e., BBB- or better) and an S&P stock rating of at least B+/M, we are left with the 9 companies in the Table. 

Bottom Line: Only two of these 9 oil and natural gas companies had a Buffett Buy Analysis that projected returns higher than 7%/yr over the next decade, namely, Cameron International (CAM) and National Oilwell Varco (NOV). Both are too risky to include in a retirement portfolio. However, ExxonMobil (XOM) is worth considering because it has the largest investment in natural gas production and is projected to have a total return close to 5%/yr over the next 10 yrs. Most importantly for you, XOM does satisfy our requirements for inclusion in a retirement portfolio: 
   1) the stock has a Finance Value (Column E in the Table) that beats our key benchmark (Vanguard Balanced Index Fund - VBINX); 
   2) the stock is an S&P Dividend Achiever; 
   3) the company’s bonds have at least a BBB+ rating from S&P; 
   4) the stock has at least a B+/M rating from S&P;
   5) the stock has had dividend growth of at least 5%/yr for the past 14 yrs, and 
   6) the company is large enough to be included in the Barron’s 500 List published each year in May. The Barron’s 500 List is particularly useful because it ranks companies by sales growth and cash flow-based ROIC (Return On Invested Capital) for each of the two most recent years. 

Risk Rating: 6

Full Disclosure: I dollar-average into XOM and also own shares of CVX.

Note: metrics in the Table are current as of the Sunday of publication. Red highlights in the Table denote underperformance vs. VBINX.

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