Techniques for Appraising the Petroleum Industry's Operating and Investment Outlook

Transcription

1 30 THE ANALYSTS JOURNAL Techniques for Appraising the Petroleum Industry's Operating and Investment Outlook By JOSEPH GORDON Editor's Note Mr Gordon points out that the principal problem of the petroleum industry recently has been to supply an unprecedented demand during a period when prices have been frozen by the Office of Price Admmlstratmn When more normal demand levels are reestabhshed and prme controls are rehnqmshed, supply-anddemand relatmnshlps m the industry will resume thelr historic function m influencing petroleum industry price and earmngs level The investment analyst who begins to study the petroleum industry for the first tlme soon finds that he is exploring one of the most fascinating businesses m the world Each division of the industry presents many facets for examination, and there is a powerful temptation to become revolved m an exhaustwe consideration of interesting techmcal detail For example, even a superficlal Inspection of the problems of producing crude oll leads one to a consideration of geology, geophysics, petroleum engineering, well drllhng techniques, and the pohtmal mechamsms whmh have been estabhshed for the control of crude oil production The student of refining technology soon runs across polymerization, catalytm cracking, and the synthetic manufacture of hqutd hydrocarbons The transportation and marketing dlvlslons of the industry have thelr own problems, techmques, and ramlficatlons Because the mdustry's technology is seemingly inexhaustible and constantly changing the analyst who attempts to keep posted on all the detail of the mdustry's affairs frequently becomes thoroughly confused or begins to mistake unimportant and sometimes unrelated data for slgmficant guideposts to the mdustry's operating and investment outlook A typlcal pitfall of another character is the strong normal

2 JANUARY, secular trend m petroleum consumption Thin is sometimes taken as assurance of an uninterrupted pemod of good earnings for representative oll companms Another is the theoretical inflation hedge charactermtlcs of large crude oll reserves underground, occamonally accepted as assurance of a strong basic trend m prices of od company shares Simple Principles for Analysis Sound knowledge and understanding of the lndustry's basic economic relatmnshlps are requmlte to successful appramal of the investment outlook of the oli shares It is only after the mare elements of the mdustry's economic relatmnshlps have been firmly fixed m mind that the technological detml falls into proper perspective One may expand thin statement and observe that it is not sufficmnt merely to evaluate the economic factors within the domestm petroleum industry, for increasingly the American oll business is becoming subject to world-wide petroleum trends For example, the development of large crude oll reserves and refining faclhtms m the Middle East is of great importance to the future investment value of the Umted States oll industry Similarly, the extent to which consumption of petroleum products may expand m countries other than the Umted States after the war is of importance to the domestic petroleum industry The petroleum industry ~s too complex and ~ts competitive relatmnsh~ps are too shifting to permit the hstlng of a few rules which will be an mfalhble guide to successful investment pohcy Nonetheless, certain principles help to maintain perspective and to reduce the chances of drastm error Earnings Tied to Price Levels 1 Earmngs of the petroleum industry, by and large, are more dependent upon the level and trend of prices of crude od and refined products than upon the level and trend of consumption Even m poor years, consumption is excellent 2 Trends m demand are slgmficant chmfly m periods of drastic change such as that which took place m the transition from peace to war and whmh will take place m the transltlon back from war to peace 3 Ordinarily operating margins of producers and refiners are more important than the volume of output In turn, operating margins are largely dependent upon the pace structure This is illustrated m the chart on page 33 (which does not include the abnormal wartime pemod) It is Important, therefore,

3 32 THE ANALYSTS JOURNAL to antlcspate periods of weakness m petroleum pmces as well as permds of strength, although obvlously neither strong nor weak prices have an equal :mpact upon the prospects and earmngs of mdsvsdual off compames Small Supply-Demand Maladjustments Affect Prices 4 In a hsghly competitive industry such as this, the relatranship between supply of and demand for off is controlling m the matter of prices When supply and demand factors are m apprommate balance, or demand m gaming faster than supply, the price structure xs almost certain to be firm to nsmg When supply exceeds demand, the barns for weakness m petroleum prices ss being estabhshed Once the supply-demand equlhbnum of the industry is upset, st usually takes longer for st to be reestabhshed than it has taken for the maladjustment to Occur. 5 It does not require a large excess of supply over demand or demand over supply to have a slgmficant effect upon the mdustry's price structure In recent years, fluctuatmns m refined product pmces have been more frequent and of wider amphtude than fiuctuatmns m crude off paces The reason is that the proratmn mechamsm prowdes a means of adjusting crude off supply to demand whde there ss no comparable mechamsm for reestabhshmg equilibrium m the refining branch of the industry, and any effort to create such a mechamsm undoubtedly would be conmdered a vmlatmn of the Anti-Trust Act by the Department of Justice Thin does not mean that excesses m crude off supply do not develop or that prolonged pressure on refined pmces wdl not find reflectson m the crude prxce structure Petroleum Demand Estimates Forecasts of demand for domestic crude oll and gasoline, made monthly by the Petroleum Economics D:vsslon of the Bureau of Mines, are excellent for the purpose intended They give the var:ous od-producmg states an unbiased basra against which each can estabhsh, monthly, average dally production allowables. Exper:ence demonstrates that the Bureau of Mines forecasts customarily lag m reflecting drastic changes m the trend of demond Furthermore, forecasts a single month m advance are not sufticlent for the purpose of oll security analysis Since the market usually antlcspates coming events, st is necessary to apprame independently the level and trend of demand three to six months m advance

4 JANUARY, Various techniques can be and have been developed for projecting demand for petroleum. Basically, the problem is one of knowing what industries and activities are the major consumers of petroleum and its products, and of projecting trends ip those industries. This leads to a consideration of business cycles, industrial production indices, and the other tools with which economists forecast uptrends or recessions in business activity. i.*. L To,*t D~.,.o!!I ~*LLO. Crude ~DEMAND GaSOll~ e 28 Co,s -- EARNINGS t ,40 Primarily there are required projections of the motorist's demand for gasoline, the home owner's demand for heating oil, and industrial and shipping demand for residual fuel. In the postwar world, it will be necessary to give greater consideration to military and naval demand than has been the case previously. Beyond this, there must be a keen realization of the seasonal factors in petroleum consumption. With the motorist the largest consumer of gasoline, the summer is seasonally the peak period of gasoline consumption and the winter is seasonally the lowest. On the other hand, the winter is the peak season for consumption of heating oil and the summer the poor season. It is possible for seasonal maladjustments in the oil industry's supply-demand relationships to take place as well as cyclical maladjustments, and for this reason both sets of factors must be carefully analyzed. Petroleum Supply Estimates Once domestic petroleum demand trends have been projected it becomes necessary to analyze the supply side of the petroleum picture. For this the Bureau of Mines monthly pro-

5 34 THz ANALYSTS JOURNAL jections of crude oil demand become valuable, assuming no major change in business trends is taking place. By relating total weekly production of crude oil and products (as reported by the American Petroleum Institute) to the Bureau of Mines monthly estimates of demand, it is possible to determine on a monthly basis whether production is exceeding demand or vice versa. In addition, it is possible to determine whether crude oil production in the various states is conforming to the allowables which the states themselves have established and whether the states have established allowables related to the Bureau of Mines estimates of demand (and currently, to Petroleum Administrator of War). A new field or group of fields occasionally will be discovered and developed in a state which does not enjoy effective proration controls, and a rapid increase in supply will take place Sometimes these increases in supply are sufficient to cause a serious maladjustment in the industry's supply-demand relationships. Thus it is necessary to watch new discoveries carefully both as to magnitude and location. To determine whether supply of refined products is increasing or decreasing, crude oil runs to refineries must also be examined, as must production of gasoline, heating oils, and residual fuels These production figures can also be related to Bureau of Mines monthly forecasts of demand. Watching Inventories--Imports The best indications of supply-demand relationships in the industry are inventories of crude oil and finished products The American Petroleum Institute reports weekly inventory data on refined products, and the Bureau of Mines issues a weekly report on crude oil stocks If crude oil or gasoline inventories are increasing at a faster rate than is justified by expansion in demand, this may indicate a developing excess of supply over demand If inventories are declining, or remain stable while demand increases, an excess of demand over supply may be indicated Of course, to be significant, trends in inventories must be related to seasonal demand and supply factors. During immediate pre-war years, the level of exports and imports of petroleum could be projected with reasonable certainty and then related to domestic supply-demand factors. Projections of United States foreign trade in petroleum in the immediate post-war period are likely to be much more difficult. Yet international petroleum factors will be more important than

6 JANUARY, ever in determining supply-demand equilibrium in the domestic industry. Although military secrecy has prevented publication of accurate details, it is well known that large increases in crude oil productive and refining capacity have taken place in the Middle East and in Venezuela. The synthetic petroleum industry in Europe, and especially in Germany, has been greatly expanded. Russian petroleum production and refinery output have undoubtedly increased. Application of General Trends to Individual Companies Assuming that a carefully documented appraisal of petroleum industry operating and earnings trends is projected, it then becomes necessary to examine the status of individual companies against the background of the industry outlook. If a sharp drop in refined products prices and refinery margins is visualized, it becomes important to know which companies are largely refiners, and how much of their crude oil supplies they purchase and at what price levels. If an increase in crude prices is foreseen, it is necessary to determine which companies are chiefly producers of crude oil and which of these have the lowest production costs. By the same token, it becomes important to know which refiners will have their profit margins squeezed by an increase in crude oil prices. If an area of the country is, likely either to be more adversely affected or to receive greater benefit from a given set of industry developments, it is necessary to know what companies have their operations concentrated in that area. If a revolutionary new refining process is developed, one should know which company or companies enjoy the inside track. Reliable information on crude oil reserves is most important in gauging the relative investment position of the various oil companies. It is extremely difficult to obtain on a comparable basis. Certain companies never release crude oil reserve figures, either publicly or privately, while a limited number of other companies publish estimates of reserves in their annual reports. Even in the latter case, one company may publish an estimate of proven reserves, whereas another company's estimates may include both proven and indicated reserves. In the matter of appraising crude oil reserves, it may truly be said that "a little knowledge is a dangerous thing," and the analyst appraising this problem would be well advised to proceed cautiously. If crude oil reserves are declining more rapidly in certain states than in others, it is imperative to know what companies have their reserves and production capacity located in those

7 36 Tl-m ANALYSTS JOURNAL states and whether they are doing anything in other areas to offset these trends. One must know which companies have efficient refining and marketing organizations, and which companies have relatively inefficient ones. Management ability and technical competence of staffs must be appraised for each company. These factors cannot be evaluated statistically, but they are of extreme importance in determining the long range success of a company's operations. For example, an imaginative, on-its-toes geological and geophysical department, prepared to step away from the beaten path, is practically indispensable to a company in protecting its crude oil reserve position; and a refining department which does not keep pace with the most modern procedures is bound to cost its company money. Some managements are more financially minded than others. Some managements have a flair for operating in a concentrated territory; others are more interested in national operations. Know-how in the foreign field, where headaches abound, is especially important. - Nor can the petroleum industry be appraised in a vacuum. Its operations are related to and affected by general economic conditions just as price action of oil shares is related to and affected by conditions in the general market. Enough has been said to.indicate that there is no easy road to success in appraising the operating and investment outlook of the petroleum industry and its leading companies. But to the analyst who is prepared to put forth the necessary effort, there is the satisfying reward of an increasing knowledge of an industry second only to the public utility industry in the value of shares listed on the New York Stock Exchange an industry which gives almost unlimited scope for the application of sound investment research and judgment... An address was made before the Society on October 25 by Albert J. McIntosh, economist for Socony-Vacuum Oil Co., on "A Forecast of Demand for Petroleum Products in the United States during the Post-War Period". Copies of the talk have been made available to members.