Why oil stocks look cheap

The fellow on the next treadmill took off his headphones and turned to me with a question.

“Why is it,” he asked, “that oil prices are over $40 but oil stocks aren’t moving?”

Now, dealing with complex financial matters when you’re trying to maintain a four-mile-an-hour pace on an incline is more of a challenge than I can handle so I made some off-the-cuff remark and refocused on trying to work off some excess pounds.

But afterwards in the shower I thought more about it. The question is probably one that a lot of investors are asking right now, given the events of recent weeks.

You can’t pick up a paper, listen to the radio, or turn on the TV these days without hearing the latest take on the energy story. Crude oil prices hit an all-time high. Gasoline prices close in on $1 a litre. Politicians rant but take no action to cut gas taxes. Gas theft drive-offs increase. CAA tells people to park their cars as a boycott. World economic growth is threatened. Next to the federal election, it’s the biggest story in the news and it cuts close to the bone as far as individual Canadians are concerned.

You’d never know it by looking at the stock market, howev. In the past month, the S&P/TSX Capped Energy Index has gained a modest 1.3 per cent in value while the Capped Energy Trust Index has dropped 1.7 per cent (to June 1).

So what’s going on? Why aren’t energy stocks going through the roof? The big brokerage firms seem to think they should be. RBC Capital Markets issued a strategy analysis recently in which it upgraded the energy sector from “market weight” to “overweight” with the comment: “Strong global growth, a favorable supply-demand balance, and disciplined OPEC behavior make this sector attractive. Valuations are also very appealing.”

But investors aren’t responding. The reason seems to be that people can’t believe — indeed, don’t want to believe — that oil and gas prices can remain at current levels for very long. So they aren’t bidding up the share prices to reflect US$40+ a barrel. They expect, and hope, that they’ll fall back to the US$35 range soon.

Stock analysts hold the same view. CIBC Wood Gundy is working on the assumption that West Texas Intermediate (WTI) crude oil price will average US$34.50 this year and US$30 in 2005. But even using those assumptions, it has a 12-month target price of  $78 on Petro-Canada (TSX: PCA; NYSE: PCZ) and about $72.50 on EnCana (TSX,NYSE: ECA). Both those targets are well above current price levels for the stocks.

But what if US$40 oil is really here to stay, at least for a while? You can certainly make a case for that scenario, factoring in an improving world economy, the failure of the U.S. to get Iraqi oil moving in any significant quantities, the terrorist attacks on foreign oil workers in Saudi Arabia, and our dependence on oil and gas for so many of the necessities of daily life, from getting to work to heating our homes.

If prices stay up for any length of time, oil company profits are going to start looking downright obscene. The media and the politicians will howl, albeit ineffectively if past experience is any indication. Meantime, shareholders will be reaping the benefits of rising dividends and, eventually, stock prices that are higher even than those currently being forecast.

Another factor working in favour of oil companies is the recent decline in the value of the Canadian dollar. The loonie’s rise depressed profits last year. By the same token, its pull-back should give a boost to earnings.

Investing in energy right now is to some degree a case of riding the tiger. But the valuations of many stocks in the sector look very attractive in the context of everything that is taking place. Just be ready to jump off quickly if the tiger decides to turn on you.

Adapted from an article that originally appeared in the Internet Wealth Builder.