Is Now The Time To Buy Big Oil?

 | May 14, 2015 08:45AM ET

This market is not one I’m overly interested in buying in size. There are simply too many red flags for our fundamental, value-driven style of investing:

  • Valuations are well above the level at which we like to buy. Buying high and planning to sell to a greater fool at a price that's even higher has never worked for me.
  • The bull is old; it could grow older gracefully, but sooner or later all things must die, gracefully or not.
  • We have just concluded the market’s traditionally strongest season. That doesn’t mean anything in some years but in more years than not, historically, the summer doldrums are real enough that Wall Street makes a big deal about not missing “The Summer Rally!”
  • QE is gone. The Fed doesn’t dare reinstate it; that would be admitting the US economy cannot stand on its own.
  • Global offerings may be better than the US, but are still only so-so. We’ve even placed trailing stops under our European and emerging market holdings.
  • China is on a knife edge, with investors actually believing the fabricated numbers from China. Sooner or later the truth will out.
  • Investor sentiment, usually wrong at major turning points, is way too optimistic.

Still, there are a few things I am willing to hold for myself and our clients even through a decline. Oil prices may take yet another dip, and take oil and gas stocks down with them. Knowing that we cannot possibly catch the exact highs or exact lows, in times of market over-exuberance if there is a quality sector providing an essential product that has already been in its own private bear market hell, it is likely the best place to begin our search for value.

Three oil and gas top-tier firms come immediately to mind: Royal Dutch Shell (NYSE:RDSa) (we prefer the RDSb shares), Total Petroleum (NYSE:TOT) and BP (NYSE:BP). That’s not to disparage their even larger brethren, Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), but those two have not fallen as much. If they should, they’ll be on our buy list as well.

When I discuss big oil, I don’t include any Russian or Chinese firms which are de facto state-owned or oligarch-owned, leaving individual investors with little say. (Many investors believe some other big foreign oils are owned by their own governments. The French government, for instance, once held just over a third of Total, a figure that is now just 1%, less than many mutual funds.)

The benefit of sticking with these major integrated energy firms is that we have virtually zero risk of default or bankruptcy. No matter how low oil prices tumble, their diversification into both upstream (exploration and production) and downstream (refining and distribution/retail sales) keeps them in good stead. When oil and gas prices are high, they make the most money, of course. But even when prices of the commodity itself are low, that just reduces the big integrated firms’ cost of feedstock for their refineries and chemicals and plastics businesses.

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If the market continues to leap ahead this year, it’s likely these companies will be carried along with the general euphoria, and with considerably less volatility than most other stocks along the way. If the market is flat, they’ll likely stay roughly where they are (though a serious elevator shaft drop in oil prices would force us to remind ourselves daily that these are long-term investments!) And if the market is down but oil doesn’t plunge to Citicorp’s projection of $20 a barrel, they will bump along, paying us more than 5.5% each to stick with them.

Let’s take a look at each of these three favorites of mine, then briefly mention the next tier down:

Wall Street is all agog over the idea that BP is a wounded bird and some clever hawk like Exxon Mobil or Chevron will swoop in and make us all rich via a possible takeover. I suppose it could happen but I was in London last week and I can assure you that the current government of the UK considers BP to be a national treasure, strictly off-limits to any takeover.

Mr. Cameron et al have been quite clear that they consider BP their franchise player. OK, he didn’t use the term “franchise player,” but you get the idea. When one company resists another’s advances, they may lose. But when a sovereign government says no, they can tie you up for years and make it clear that you will be far the worse for wear. The British are a very civil people, well-mannered and kind to a fault. But if you rile them, you will be reminded that these pleasant folk are descendants of decidedly truculent Picts, Celts, Scots, Angles, Saxons, Jutes, Belgics, Bretons, Vikings, Normans and Britons. Unless the Brits decide on their own to allow BP to be acquired, I don’t think there is a company quite up for this fight. So, perhaps alone among analysts, I am buying BP on the fundamentals, not any takeover rumors.

All three companies have a higher weighted average cost of capital (WACC) than their return on capital (ROC) for the past quarter or two, of course, but longer term, over the past five years, BP’s ROC has averaged 14%, well above its mid-single-digit WACC — and that includes the entire time after the April 2010 Deepwater Horizon fiasco. This event caused BP to divest significant assets but did not include a sizable retrenchment from the USA. Although BP is clearly a British firm, its largest employee base and biggest investments remain in the US. BP is a company with $359 billion in revenues as of 2014.

More than half the liabilities from Deepwater Horizon have been dealt with, and the remainder may yet be reduced. Anyone avoiding BP because they believe the maximum of $18 billion in remaining possible civil fines and liabilities, subject to downward revision, will drive the company into the ground are mistaken. More importantly, we are pleased to own both shares in and options on a fine company at a fine price.