Investment: Should you invest in... oil companies?

UNTIL THE recent reorganisation of the FT sectors of the UK stock market, oil companies fell into two categories. One was the "upstream" exploration and production stocks that located oil and got it out of the ground. The other was "downstream" integrated oil companies, which may have an involvement in production, but also transport, refine and sell the commodity. In recent years, both groups have come under pressure.

The key problem has been the price of oil. Most investors will remember that the high inflation of the 1970s was sparked off by the oil crisis of 1973. But, since the end of 1985, apart from a blip in the third quarter of 1990 (after Iraq invaded Kuwait) when the oil price briefly rose to more than $40 (pounds 25) a barrel, prices have generally been much lower, falling below $10 per barrel towards the end of 1998, before recovering.

"The upstream side is oversupplied and likely to remain so. The oil price is one factor, but another problem is that refining margins have not been particularly good either," says Jeremy Andrews of stockbrokers Greig Middleton. "This is one of the reasons we like Shell. It is predominantly (70 per cent) a downstream business, which has meant it can cope with a prolonged fall in the oil price, which is what we had for some considerable time."

The result has been a round of mega-mergers, often driven by a desire to cut costs.

But Tessa Kohn-Speyer, of Barclays Stockbrokers, says: "The key thing at the moment is that prices are stable and that Opec compliance [with production quotas] also looks stable. This has continued to push share prices up in line with rising oil prices."

There is no guarantee, however, that these benign circumstances will continue. "The fact that compliance is at a higher level has succeeded in cutting supplies," she adds, "so that you now have the possibility going forward of some producers `cheating'. It is possible that some countries, such as Venezuela, might think that they can get away with releasing a bit more supply on to the market."

This would, of course, keep prices down, which would turn the screw on production and refining costs, a factor in many of the mergers.

Mr Andrews says: "Not only should it [Shell] benefit from its own merger plans but from everybody else's mergers as well. This is particularly true in the US market where Shell will have around 15 per cent, roughly the same as Exxon/Texaco and just behind BP Amoco. In a very short space of time, you will have gone from eight large players in that market to four or five."

He also notes the problems faced by firms whose business is primarily to get the stuff out of the ground. "When you had oil at around $26 per barrel, which it was from 1979 to 1986, you saw a lot of deep offshore oil production at very high cost. What Shell is trying to do is get closer to the owners of rights to land-based reserves, such as those around the Gulf, to take advantage of cheaper production."

"Share prices of oil companies are very much linked to the oil price," says Ms Kohn-Speyer. "When the oil price hit its low at around $10 per barrel this was a level at which they simply could not make a profit."

This is one reason analysts are leaning more towards "integrated" companies rather than the exploration stocks,

Despite the dominance of the larger stocks, Ms Pratsch urges investors not to ignore the rest. "Big is beautiful, but it is not the only scene. There is still a place for the smaller exploration companies that are nimble enough to exploit geographic niches that larger companies might not want to get involved with."

Ms Kohn-Speyer said: "BP has risen so much on the back of its various mergers that it is still looking rather expensive, but it is still a very well-managed company. Our current ratings are that BP Amoco is a hold, but Shell is definitely a buy."