Investors still drilling for value in the oil sector

With rising demand meeting tightening supply, oil stocks are on the up, says Jenne Mannion

The oil giant Shell has rocked the City by overstating its reserves, but investment commentators say that is no reason to steer clear of the whole sector. There are plenty of quality oil companies to be found, at a time when the oil price is surging.

Carl Cross, an investment director at the stockbroker BWD Rensburg in Leeds, West Yorkshire, says the Shell debacle is an isolated case and will not affect the fortunes of other oil stocks. It is far more important to consider the high oil price and the individual quality characteristics of companies, he argues.

Well-run oil companies are raking in the profits while the price remains high. This week, the crude oil price was trading at around $32 a barrel, but had reached $37 in recent weeks, marking a 13-year high. The price was not expected to stay at such high levels for so long, so many company earnings have been beating forecast expectations, resulting in higher share prices.

Craig Pennington, a global oil sector analyst at the fund manager Schroders, says the price has remained high in recent years for several reasons. Last year, there were supply-side shocks such as the war in Iraq, civil unrest in Nigeria and a strike in Venezuela.

Although many of these countries still have unresolved issues impacting oil production, it is a broader combination of tight supply and strong demand that is keeping the oil price above $30 a barrel. In particular, there have been low gasoline supplies in the US and higher-than-expected demand for fuel as last winter was colder than usual there. Additionally, demand in the rapidly growing Chinese market has been particularly strong - a recent report by the official Chinese news agency showed that imports rose 35.7 per cent year on year in the first quarter of 2004.

And there could be further tightening of supply this year. "The biggest risk to supply will likely be the third quarter, following planned elections in Iraq and the withdrawal of substantial numbers of US troops," Mr Pennington said.

The higher oil price means good companies should continue to deliver strong performance. Many industry commentators forecast the price to settle between $25 and $30 a barrel, up from forecasts as low as $16 two years ago. This paints a rosy picture for oil companies, as their production and exploration costs are not connected to price movements.

There are several ways to invest in oil stocks. One of the easiest and most straightforward is by buying into UK-listed shares though any stockbroker. Household names such as BP - the UK's largest company by market value - may appeal, but there are also less well-known stocks to choose from such as Premier Oil, Paladin Resources and Cairn Energy.

Among these smaller companies, Cairn Energy has had a particularly successful year. The share price made another leap last week following its third major discovery of oil in Rajasthan, India. Cairn could be looking at a total of one billion barrels of recoverable oil in Rajasthan just from these three strikes, and it still has more than a year of its exploration licence to go, so it may find more.

If you are investing in UK oil stocks, you cannot ignore the impact of the weaker dollar, according to Ivor Pether, head of portfolio construction at Royal London Asset Management.

Mr Pether explains that, although listed in the UK, big oil stocks like Shell and BP report in dollars, and the lower dollar has negatively affected dividends paid to UK investors. He believes the impact of this is often overplayed, however, and partially offset by the fact the weaker dollar is beneficial to commodity prices, including oil.

Royal London is holding on to its positions in Cairn Energy and BP, and is confident on the prospects for both companies. However, both have performed strongly this year, particularly Cairn due to its string of exploration successes in Rajasthan in the past few months. Mr Pether said: "Cairn Energy has performed exceptionally well, and there is a degree of finger crossing that they can maintain their record of drilling success. There will continue to be a lot of news flow over the next six months as they sink new wells and appraise existing discoveries. Although the shares may look a bit overheated at the moment, there is still plenty of upside potential."

Mr Pether said oil service companies have lagged behind the rest of the oil sector and he is waiting for a buying opportunity. Among companies of this ilk, Royal London favours Expro International and John Wood Group, both of which provide oil-field services throughout the globe. Wood has been disappointing since it floated on the stock market in 2002, due to problems with its gas turbine division in the US, leading the share price to fall despite the oil price rises.

"Given the higher oil price background you would expect the environment for oil service companies to also improve quite significantly. This must just be a matter of time until the knock on effects of higher capital expenditure by the oil majors come through," Mr Pether said.

You don't have to try too hard to hunt down UK oil stocks. Mitch Hopkinson, an independent financial adviser at M2 Financial in Nottingham, said that by investing in the broader UK market, you are inevitably gaining exposure to this area. The oil sector represents 13 per cent of the FTSE All Share index and few fund managers would have zero exposure to these companies in their portfolios.

You can also buy into international oil companies. This can be done through most stockbrokers which have relationships with dealers in other countries, although the charges will generally be more expensive as you have to pay two sets of broker fees. It is worth noting that UK brokers do not research and provide advice on international stocks as thoroughly as they would for UK-based companies. So it is probably easier to gain international exposure to the oil sector through a managed fund.

Neil Rogan, manager of the Gartmore Global Focus fund, holds three oil stocks. The sector therefore accounts for 12 per cent of his fund, versus 7 per cent in the MSCI World Index. The US company Apache, he said, is very cheap. In 2003 the company purchased some American assets from BP, which are being successfully used to enhance their own earnings. Despite having had a strong run the stock is still trading at a low valuation considering the long-term outlook.

Mr Rogan also holds the US-based ConocoPhillips, which explores for and produces petroleum and natural gas. However, more than 70 per cent of its earnings come from refining and marketing, which are experiencing a period of high returns due to changing US regulations and years of under-investment. Mr Rogan describes this as a relatively low-risk stock, which again promises good growth yet is cheaply valued.

In the UK, he has recently bought Shell. "The company has some difficulties but the share price has fallen substantially in anticipation of a worst-case scenario," he says. "The cheaper price means the risk-reward profile is very much more attractive, particularly as the shares pay a good dividend."

While there are no dedicated oil funds per se, the JPMF Natural Resources fund has a high exposure to global oil stocks. Ian Henderson, the manager, has recently increased exposure to oil from 25 per cent to 32 per cent of the portfolio, because he believes the sector is attractively valued based on his expectation that a high oil price is sustainable and company valuations remain attractive. Most recently, Mr Henderson bought stakes in two Canadian stocks, Encana and Nexen.

If looking for a more regionally specific fund, there is an abundance of oil stocks to be found in Russia, of which the biggest include Lukoil and Yukos Oil. A good way to buy into this market is through the JP Morgan Fleming Russian Securities investment trust. This fund is 45 per cent exposed to oil and gas stocks.

The Baring Emerging Europe investment trust has half of its portfolio in Russia and a significant portion in oil stocks. This investment trust's top holdings are Yukos and Lukoil. You can also buy investment trusts through your stockbroker. Of course, Russia is still regarded as a highly volatile market, and political and financial factors will also affect the fortunes of these companies.

AND HOW THE ANALYSTS VIEW THEM

Carl Cross, investment director at BWD Rensburg, is a buyer of BP, the UK's largest company. He describes BP as a proactive company where management is committed to delivering shareholder value.

"Unlike Shell, this company has been growing its reserves. It has made acquisitions in the last few years of Amoco and Arco, which have resulted in a much wider reserve base, and enabled aggressive cost-cutting." Mr Cross says BP's reserve replacement ratio, which is the key factor affecting Shell, is sound. He is not buying Shell.

Mike Felton, manager of the Isis UK Prime fund, is not buying Shell either, but is comfortable holding the company despite the recent scandal. He also favours BP.

"Although Shell has recently gone through a turbulent time we feel the likely changes to the board structure will improve the way the business is managed. The bad news is known and therefore reflected in the share price. BP and Shell are attractive businesses which generate strong cash flow, which is used in a positive way for shareholders.

"Shell pays a large dividend and yields more than 4 per cent, and BP has recently announced a large share buyback operation which will support the share price."

Paul Kavanagh, a stockbroker at Killik & Co in London, supports this view of Shell and sees the recent dip in the share price as an opportunity to buy the stock cheaply.

For investors who are prepared to take a punt on the Alternative Investment Market (AIM), Hardman Resources could be worth consideration, says David Stevenson, manager of the SVM UK Opportunities fund.

Hardman Resources is an oil exploration company listed on both AIM and Australian Stock Exchange. The company has projects in eight countries and a major presence in the emerging petroleum province offshore Mauritania, West Africa.

Hardman participated in successful exploration and appraisal drilling programmes in 2002 and 2003. "With substantial discoveries already and scope to add significantly to existing reserves the company is now in a transition phase from a small exploration company, and should achieve a much wider ownership and broker coverage," Mr Stevenson said. He expects a full UK listing in due course.

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