In light of the market's recent broad based selloff, energy offers some very attractive entry points, based on the strength and stability of its businesses, attractive and growing dividends and low valuations.
The recent escalation of tensions in Israel and Gaza highlights the very tenuous environment in the Mideast. We think geopolitical issues will continue to pop up and will push oil prices toward the higher end of their trading range, providing the group a tailwind.
We initially recommended Occidental Petroleum during the first week of October, in which we highlighted many of the company's appealing investment characteristics: a strong management team led by President & CEO Steven Chasen, a great balance sheet with a net debt to total capital ratio of 5%, a secure resource base with 60% of oil and gas production coming from the U.S. and relatively secure international operations with a primary focus in the Middle East being the United Arab Emirates and shareholder-friendly strategy of growing production by 5-8% per year and returning incremental cash flow to shareholders by steadily increasing the dividend (a greater than 15% growth rate since 2002).
Since that recommendation OXY's shares are down more than 13%. While some of the decline was likely due to the ensuing drop in energy prices and to the overall market decline since the presidential election, another factor was investor reaction to Occidental's third-quarter earnings call on Oct. 25.
On that call, the company reported solid results, with flat production that was equal to the record production of the previous quarter and up 4% from the third quarter of 2011. Domestically, the company had record production for the eighth consecutive quarter, up 8% from a year ago. But the company also highlighted how, in order to sustain historic returns on capital, its drilling costs would have to come down (production costs were $15 a barrel for the first nine months of 2012 compared with $12.84 in 2011). Unless and until costs declined, OXY would slow its drilling program.
In the event that costs don't come down, and the company cannot maintain acceptable returns on capital, OXY's strategy will change, such that the company will find other ways to improve shareholder returns. In fact, the CEO was pretty vocal in his frustration of OXY's poor stock price performance, and made it clear if the market didn't give the company credit for increasing shareholder value and that they would try to address that with more aggressive dividend or share repurchase strategies.
We would add to OXY at its current stock price.
RDSB is one of the five major integrated oil companies, with operations in exploration and production, refining and marketing. The company delivered solid earnings in its most recent quarter, slightly beating consensus estimates. Highlights for the quarter included E&P results in line with expectations, better-than-expected refining results and chemical results below estimates due to reductions in European capacity and the impact from Hurricane Isaac in the Gulf of Mexico.
The company gave an update on its large development projects, which continue as planned. As these major projects from Qatar, Canada, Kazakhstan and the U.S. Gulf of Mexico come on stream over the next three years, Royal Dutch should see a major structural jump in its free cash flow generating capability. Management has indicated to investors that a major portion of this increased cash flow of $7 billion or more will go to boosting dividends and shareholder value. At less than 8x 2013 earnings estimates, a free cash flow yield approaching 8.3%, and with a 5% dividend yield, Royal Dutch Shell offers investors a conservative and opportunistic yet relatively stable way to invest in the energy sector.