With Oil Peaked For Now, Contrarians Likely Will Turn To Refiners

There aren't many energy stocks sitting nearly 60% below their highs, but as the crude oil bull market has continued in 2008, refiners have gotten crushed. The explanation for why refiners fare poorly in the face of rapidly rising crude prices is pretty simple. Refiners buy crude oil, refine it, and resell it to users of gasoline and other refined products like jet fuel. If the price of your core cost component is soaring and end demand for your finished product is falling because of high prices curbing demand, profit margins will contract pretty aggressively.

As a result, shares of refiners such as Valero Energy (VLO) have been pummeled. After earning about $8 per share in both 2006 and 2007, profits for VLO are expected to fall 50% this year, to around $4 per share.

But what happens if crude oil stops going up so fast? Already we have seen per barrel prices top out in the 140's and trade down to the low 120's and gasoline prices nationwide are below $4 per gallon again. Frankly, the backdrop for refiners really can't get much worse that is has been so far this year. As a result, VLO shares have fallen from a high of 78 last year all the way down to the 30's.

There appears to be some value here if investors are willing to be patient and wait out a turn in refining industry fundamentals. Let's value VLO stock two different ways and see what we come up with.

1) P/E Ratio Valuation

Let's assume normalized EPS of $6 per share, up from the current run rate because conditions stand a good chance of improving, but 25% below the levels of 2006 and 2007. Use a 10 P/E and we get $60 per VLO share.

2) Asset Liquidation Valuation

Valero has sold 2 refineries since last year for about $3 billion. Those two refineries produced a total of 250,000 barrels per day. Valero now owns 16 refineries producing 3 million barrels per day. Let's assume they sold all of their refineries for the same price. That would net them $36 billion, or $66 per share.

As a result of the tremendous value that appears to be embedded in the stock, VLO is being added to the Peridot Blog Model Portfolio today. Refining margins stand a good chance of improving over time, as long as crude oil prices behave better, which would likely positively affect VLO's earnings per share, earnings multiple, and in turn, the share price.

Full Disclosure: Long shares of VLO at the time of writing

Did Gas Use Really Drop to Five-Year Lows?

This story is a few weeks old, but I came across a Wall Street Journal article dated July10th with the headline "Gas Prices Spur Drivers to Cut Use to Five-Year Low." I had mixed emotions when I read that. On one hand, lower gas use will ease the upward pressure on prices. On the other hand, as we have seen time after time, when prices go back down consumers ramp up use again, so the problem never gets fixed. Hence, many claim the solution for high gas prices is... even higher gas prices.

After reading that headline I wrongly assumed that U.S. gasoline use had actually fallen to levels not seen since 2003. After all, the article pointed out "gasoline consumption dropped 3.3% from last year to 9.347 million barrels a day."

The very next sentence, however, gave us the real picture. It reads "For the first week of July, that is the least drivers have used since 2003, when consumption was 9.05 million barrels a day."

Wait... what? Gasoline demand reached a five year low, but isn't 9.347 barrels per day a lot more than 9.05 million? In reality, gas demand has risen 3.3% since 2003. What the author was trying to say was that the year-over-year change in demand was the lowest in five years.

I only point this out because many people have quoted this data and would have you believe that Americans are really cutting back on gasoline use. In reality though, even though prices at the pump have more than doubled over the last five years, we are still using 3% more gas today than we did then. Demand destruction is happening this year, just not in any meaningful way if you look at the bigger picture.

Did Wall Street Forget About Chesapeake Energy's Haynesville Shale Monetization?

Back on March 26th I pointed out that earnings estimates for Chesapeake Energy (CHK) appeared to be too low. At the time the company had just released a bold exploration and production plan for its leaseholds in the Haynesville Shale, but Wall Street was only expecting the company to earn $3.50 in both 2008 and 2009, which seemed way too conservative.

Since then estimates have increased to over $4 per share, which is closer to reality, and CHK stock soared from $47 in late March to north of $70 on July 2nd. Such a large move in the stock was prompted by two events; a sharp move in natural gas prices to above $13, but more importantly, Chesapeake's announcement on July 1st that it had successfully monetized its Haynesville Shale acreage.

Under a joint venture with Plains Exploration (PXP), Chesapeake will sell a 20% stake in its Haynesville Shale acreage (440,000 acres) for $1.65 billion in cash. Not only that, but PXP has also agreed to pay 50% of the development costs for the remaining 80% of the play (which CHK owns), up to an additional $1.65 billion. As a result, Chesapeake is swapping a 20% economic interest in the Haynesville shale for $3.3 billion, with half of the cash paid upfront, and the other half over the course of several years as the land is developed.

Considering that the Haynesville Shale was not even on investors' radar screens earlier this year, this deal is pretty astonishing. The Haynesville represents only 3% of CHK's net acreage, 0.3% of the company's proved reserves, and 21% of the company's risked reserves (proved reserves plus risked, unproved reserves), but the Plains joint venture values Chesapeake's Haynesville acreage at $16.5 billion.

That is especially impressive because even at the all-time high of $74 per share, Chesapeake's equity market value was only about $40 billion. Not surprisingly, those highs were achieved the day after the PXP joint venture was announced.

Over the last few weeks, however, natural gas prices have fallen from $13 to $10 per mcf. As I have written about many times before, CHK shares track gas prices in the short term despite the fact that the company hedges most of its production, thereby insulating it from the volatility of the near term spot market. As a result, CHK shares have fallen from the July 2nd intraday high of $74 to a closing price of $47 on Wednesday.

Is such a move down warranted, especially given the recent Haynesville announcement? Well, Chesapeake has hedged 81% of their remaining 2008 production and 54% of their 2009 production. I would have to say July 2008 prices really have little impact on CHK's financial performance. Still, traders will use the stock as one of their main natural gas trading vehicles, so investors need to live with this price action.

For those who are bullish on natural gas and are fans of Chesapeake, but missed getting in on the stock as an investment, short term market fluctuations have once again provided you a chance to purchase shares for 36% less than their level three weeks ago. CHK's market value is now only $25 billion, versus an implied valuation of more than $16 billion just for the company's Haynesville Shale acreage. Given that single play represents only a fraction of Chesapeake's natural gas assets, this recent collapse in stock price appears to be another case of stock market short term irrationality.

Full Disclosure: Long shares of CHK at the time of writing

General Electric Earnings Could Initiate Oversold Bounce

General Electric (GE) will be the first important report of second quarter earnings season. After last quarter's shocker, a stabilizing picture at the industrial conglomerate could very well help this market get a much needed and long overdue oversold bounce. With sentiment so low right now, even generally in-line earnings might be enough to halt the market's slide.

Coming into this earnings season, consensus estimates call for S&P operating earnings of $88 for 2008. Interestingly, that would match the market's 2006 level, and represent an increase of 6% over 2007. A huge headwind for the market has been the fact that earnings estimates coming into the year were way too high and downward revisions have been continuous. Stock prices will have a hard time rebounding until earnings stabilize.

Amazingly, estimates for 2009 are still way too high. Analysts right now are sitting at $109 for the S&P 500 next year, which I think is insane, quite frankly. If those numbers prove accurate this market will be off to the races by the first half of next year. That aside, if second quarter earnings are okay (not far below current estimates) hopefully we will get another short term oversold bounce, much like the two we have already seen during this year's market ugliness.

A better report out of General Electric would go a long way to getting the ball rolling in that direction (GE reports before the market opens on Friday).

Full Disclosure: Peridot clients were long GE at the time of writing

Merrill Lynch Somehow Cuts Target Price on GM by 75% in 1 Day

Academic studies have found that Wall Street analyst stock recommendations trail the market and do so with more volatility. As a result, investors who use sell side research should be careful to pay attention to certain data points that analysts have spent hours putting together, but to completely ignore price targets and ratings and instead coming up with their own opinion on the ultimate value of a stock.

The latest example that illustrates this point is the call we got out of Merrill Lynch today. ML's auto analyst downgraded shares of General Motors (GM) from "buy" to "sell" and slashed the price target from $28 to $7 per share. That's right, this analyst thinks GM is worth 75% less than it was 24 hours ago.

As for how to value GM, I think it is simply too difficult to do so. It is nearly impossible to estimate future legacy costs, and trying to figure out what a reasonable profit margin on cars should be is simply a guess because they are not even making money at all and their competitive position has deteriorated since they were last in the black.

Besides, if an analyst can tweak their model and get $28 one day and $7 the next, that is a pretty clear signal to me that valuing GM right now is just not something anyone can do with a large degree of confidence.

Anybody think GM is a buy at 10 bucks? If so, why?

Full Disclosure: No position in GM at the time of writing

Illustrating the Bullish Case for Oil

Those of you who follow the oil markets know that a core bullish argument for rising oil prices over the long term is the growth in demand from overseas, most notably China and India. Those two countries alone represent 36% of the world population, so if their demand rises steadily, the logic goes, lower oil prices are a tough accomplishment.

On Monday a very telling statistic mentioned on CNBC caught my eye. I did not catch the source of the data, so we will have to assume it is correct, but take a look at this:

Barrels of Oil Consumed Per Person, Per Year:

United States: (25) Japan: (14) China: (2) India: (1)

Barring huge oil discoveries in coming decades (highly unlikely) or a dramatic shift to alternative fuels (more likely, but by no means assured), imagine where oil would trade if China and India reach 5-10 barrels of oil consumption per person annually.

As for a more short term view, I have been taking some profits in oil-producing stocks lately. The sudden move to the high 130's per barrel makes me think the risk-reward trade-off is more balanced now. The next $20 move could be in either direction pretty easily (up if we have a bad hurricane season, or down if it is mild and we get a common correction) and the recent leg higher looks a little extended to me (see the chart of the U.S. Oil Fund ETF (USO) below).

I am not getting into the short term energy price prediction game, but I think taking some profits is a good idea after such a big move, as that matches my investing discipline. Long term, it is pretty hard to justify selling large blocks of energy stocks given that we can look at numbers such as those above and see that without dramatic change, the oil bull market remains intact.

Full Disclosure: No position in USO at the time of writing

Would Offshore Drilling Bring Down Gas Prices?

With gasoline prices nationally surpassing $4.00 per gallon, politicians are revisiting the idea of allowing oil companies to drill off the coasts of the continental U.S. as well as the National Wildlife Refuge in Alaska.

Alaska is probably not going to happen for environmental reasons, but what about the idea of allowing the states to decide if they want to allow offshore drilling in their areas or not? I think that plan has some merit, since it takes into consideration the potential negative impact on tourism and other issues in certain areas. States that feel the benefit will be outweighed by the costs can take a pass, but other states can allow it if they see fit. Localized decision making on this issue seems better than a federal mandate.

That said, just how much benefit would be gained from such drilling? Unfortunately, not much.

From the AP:

"The 574 million acres of federal coastal water that are off-limits are believed to hold nearly 18 billion barrels of undiscovered, recoverable oil and 77 trillion cubic feet of natural gas, according to the Interior Department."

If we assume it will take 5 years to get the first drop of oil out of the ground and into our gas tanks, that the fields discovered have a useful life of 20 or 30 years from that point, and that we will be able to collect every single barrel of oil that is projected to be there (not a certainty by any means), we are looking at an incremental increase in domestic production of ~700 million barrels per year, on average. The U.S. is expected to consumer 7.45 billion barrels of oil in 2008, so 700 million represents about 9% of our consumption.

Given that world demand for oil is rising so much, the offshore oil we may be able to drill out of the ground would have little impact on gas prices because the oil market is a worldwide exchange. If we just had a U.S. oil market, then yes, it would have a decent impact, but that is simply not the case.

As a result, it is hard to see how more offshore drilling would impact gas prices at the pump in any measurable way. Even if world oil consumption was held constant, we could potentially increase global supply by about 2%. An equal drop in price would bring $4.09 gasoline down to $4.00 per gallon. It just does not help solve the real problem.

That said, it would certainly prevent our energy dollars from being shipped to the Middle Eastern oil-rich countries, so we could keep that money here. Of course, that means our oil companies in the U.S. will make even more money than they are right now, and people are already complaining about record profits for the energy industry even without offshore drilling.

Honda Previews Future of Compact Vehicles

It will take time, but this kind of introduction shows we do have the ability to transform our domestic vehicle fleet in order to greatly reduce oil consumption from transportation, which represents the vast majority of our energy use. As 5% of the world's population using 25% of the world's oil, even a 10 or 20 percent drop in our consumption would meaningfully impact the global supply and demand picture for crude oil, which is hitting new highs today at nearly $140 per barrel.

From the Associated Press:

Honda rolls out new zero-emission car

Monday June 16

TAKANEZAWA, Japan (AP) -- Honda's new zero-emission, hydrogen fuel cell car rolled off a Japanese production line Monday and is headed to Southern California, where Hollywood is already abuzz over the latest splash in green motoring.

The FCX Clarity, which runs on hydrogen and electricity, emits only water and none of the noxious fumes believed to induce global warming. It is also two times more energy efficient than a gas-electric hybrid and three times that of a standard gasoline-powered car, the company says.

Japan's third biggest automaker expects to lease out a "few dozen" units this year and about 200 units within three years. In California, a three-year lease will run $600 a month, which includes maintenance and collision coverage.

The fuel cell draws on energy synthesized through a chemical reaction between hydrogen gas and oxygen in the air, and a lithium-ion battery pack provides supplemental power. The FCX Clarity has a range of about 270-miles per tank with hydrogen consumption equivalent to 74 miles per gallon, according to the carmaker.

The 3,600-pound vehicle can reach speeds up to 100 miles per hour.

John Mendel, executive vice president of America Honda Motor Co., said at a morning ceremony it was "an especially significant day for American Honda as we plant firm footsteps toward the mainstreaming of fuel cell cars."

The biggest obstacles standing in the way of wider adoption of fuel cell vehicles are cost and the dearth of hydrogen fuel stations. For the Clarity's release in California, Honda said it received 50,000 applications through its website but could only consider those living near stations in Torrance, Santa Monica and Irvine.

Initially, however, the Clarity will go only to a chosen few starting July and then launch in Japan this fall.

Spallino, who currently drives Honda's older FCX and was also flown in for the ceremony, said he will use the Clarity to drive to and from work and for destinations within the Los Angeles area. The small number of hydrogen fuel stations is the "single limiting factor" for fuel cell vehicles, he said.

"It's more comfortable, and it handles well," said Spallino of Redondo Beach. "It's got everything. You're not sacrificing anything except range."

Large Caps on New Low List

In addition to Verizon (VZ), mentioned in my last post, there continue to be attractively valued large cap stocks hitting new lows in the latest market drop. Both of these names sell for about 13 times this year's earnings and 12 times next year's estimates. Pretty cheap valuations for both of them. 

General Electric (GE) ~$30

Fortunately for those who have owned the stock for a while, the days of investors paying 30 or 40 times earnings for this industrial conglomerate are over. With a far more reasonable valuation at hand, investors can actually get some value out of GE shares. Due to the company's high exposure to financial services (they lend money to many big ticket customers to aid in financing equipment purchases), GE stunned analysts by missing first quarter earnings estimates and ratcheting down its outlook for the full year. As a result, GE shares made new lows under $30 per share, yield a dividend of over 4%, and now trade at a discount to the overall market.GE followers are used to the stock fetching a premium to the market, but value investors finally have an intriguing market bellwether to consider adding to their portfolios.

Microsoft (MSFT) ~$27

The Yahoo hangover seems like it will never end, but it will at some point this year. Before the Yahoo offer was made, MSFT's business was clicking on all cylinders and the shares had reached the mid thirties. We can argue whether getting Yahoo would boost MSFT's financials or not, but even if we assume no incremental benefit one way or the other, it is hard to make the case that MSFT shares are only worth 27 bucks. Either way, a move back into the thirties is likely. While it would happen pretty quickly if Yahoo finally decided to remain independent and the end of the saga finally arrived, even a MSFT/YHOO combination would likely result in a higher stock price in the intermediate term, as Yahoo has little bargaining power to extract an excessive purchase price above the $33-$34 offered previously.

Full Disclosure: Peridot clients are long shares of the companies mentioned at the time of writing

Backlogs Are Overrated

Just a quick note before I head out for the weekend. In the face of oil peaking at $135 per barrel in recent days we have seen many of the airlines cancel planned deliveries of new planes they were going to add to their fleets over the next few years. Those plane orders are now unnecessary as the carriers are cutting capacity.

The big point here is that investors often go gaga over industrial suppliers' backlog. The longer the backlog the more predictable their revenue stream over the longer term, or so the investors would have you believe. Due to long lead times customers do have to place orders far in advance, often years ahead of time. Hence, the suppliers report their backlogs to investors to give them an idea of future business.

All of this appears to be very important, except for the crucial point that a customer (an airline for instance) can simply cancel their orders whenever they want since they are not binding. A large backlog may look really nice, until customers start canceling orders.

Now, would I prefer a large backlog to a small backlog? Of course. That said, I think backlogs in general are overrated on Wall Street since the orders are not binding. As a result, backlogs don't always translate into revenues.