The Most Prescient of the Oil Majors

 | Mar 26, 2012 | 2:00 PM EDT
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In my column a week ago, I promised to drill down a little bit more on the integrated-oil space -- and on which stocks are worth owning for the long haul.

In that column I tried to show that, for the biggest six of these, the limiting factors have been their growth profiles, as shown through their volumes. All of these -- Exxon-Mobil (XOM), Chevron (CVX) and Conoco-Philips (COP) in the U.S.; British BP (BP); French Total (TOT); and the Dutch Shell (RDS.A) -- have experienced a slowing of total volumes. Oil prices continue to rise, so this isn't an immediate threat to profits. However, it does have a certain medium-term impact on their respective stock multiples, as well as what we should be willing to pay for those multiples.

Because of this, lately the mega-cap oil companies have become some of the lowest-beta plays in the market, and not nearly as directly correlated with crude prices as they were throughout the 2000s. In an era of increasingly volatile crude prices, some of these names had been the most swashbuckling of medium-term investments, but now Chevron and Conoco can be held almost as safely as Kraft (KFT) and Johnson & Johnson (JNJ) -- and for the same reasons.

Well, maybe it's not quite at that level of safety. But the most interesting of these mega-caps, and the ones that are set to generate the best returns over many years, are those that can somehow find new volumes to generate and spike their price-to-earnings ratios with some special sauce. They're the ones delivering some outside-the-box projects that will allow them to grow once again, as they have always done since the 1950s.

In crude oil, this is getting more and more challenging. I could spend five columns outlining the difficulties, both physical and economic, to growing volumes in crude production. Of course, the majors will continue to do it, and they will need to do it.But the big growth is going to come some from other place -- in natural gas and in liquids.

It's not just the shale gas revolution that has made this direction clear. If you track the latest findings of new fossil fuel reserves in the oceans, on land and in the Arctic, you'll find that their geological composition contains a larger percentage of natural gas and natural gas liquids (NGLs) than does crude. That's another function of advancing exploration technology.

For the oil majors, this swap to more gas and gas liquids makes increasing sense on a financial level. In more risky areas in the Middle East and Africa, government leases require full expenditure for development and greater rebates to sovereigns. In light of the places where crude oil is being found now -- in Iraq and Nigeria and Libya and Egypt -- the rule is, "You pay all the costs of development and give us back a big proportion of what you find." In contrast, development of offshore natural gas and shale leases allow the oil companies to keep a much larger proportion of the profits.

That's provided that there are profits. Natural gas has been a recent disappointment, of course, with U.S. prices under $2.50 per Mcf. But, clearly, this must change.

So, for me, it's pretty simple picking some winners. I want the most forward-looking majors that have been unafraid to invest in natural gas and NGL production, knowing that their profit horizon is still several years away. From my perspective, a few of the majors have done a better job than others as far as that's concerned. Exxon's big 2009 buy of XTO Energy for $41 billion proves that you can be too aggressive into the space. Still, I continue to believe that taking the opportunity to become the No. 1 producer of domestic natural gas will ultimately pay off. The most measured moves I have seen have come from Shell.

Through careful investment, Shell has managed to develop a terrific portfolio of shale and other natural gas assets, both here in the U.S. with the East Resources buy in 2010 and in Canada, where the company recently entered into a joint venture deal with PetroChina (PTR). In February, Shell bought Mozambique-based Cove Energy, whose main asset is an offshore natural gas reserve thought to contain 30 Tcf (about 5 billion BOE, or barrels of oil equivalent).

Shell also recently bought a site for a new LNG plant in Canada. The company claims that, once finished, this will dwarf the size of the largest LNG plant already in operation in Qatar. At the recent Cambridge Energy Research Associates conference in Houston, Shell CEO Peter Voser spoke with such enthusiasm about the future of natural gas that moderator Daniel Yergin interrupted him to ask: "You still produce crude oil too, don't you?"

There are only slight differences in the outlooks and strategies of the big oil majors, to be sure. All are in both the crude and natural gas businesses. But, in subtle yet significant ways, I like the plans for both Exxon and Shell -- and, right here right now, I am particularly in favor of Shell's strategy. This is a core holding recommendation.

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