Forbes: Oil Stocks? Still? “Royal Dutch/Shell Group is infamous for the scandal of its overstated reserves, resulting in a management ouster. The chastened company has since cut reported reserves by 25%.” Posted 8 June 2005

By Richard C. Morais,

No, it's not too late. In fact, there are some that are truly undervalued. Forget price/earnings ratios and book values. Look at the value of their reserves.

Dadgummit. Missed buying oil stocks when West Texas Intermediate traded at $30 a barrel 18 months ago, but high oil and gas prices are here to stay for a while. Oil is one of the few industries that is reliably going to gush cash. If that rant approximates your frustrations at having missed a buying opportunity in the run-up to this energy bull market, don't despair. There's still a way to get in.

One rule: Don't be fixated on the fluctuating price per barrel, which hit a $58 high in early April, tumbled to a still-high $47 in mid-May and has inched back up to $50. The bullish case for oil stems from a growing world economy-you know, China and India-that will ensure increasing demand and stock-propelling earnings.

When picking energy companies, their price/earnings multiples are of little help. Energy stocks these days have low P/Es, largely because the market thinks oil prices will crash as they have in the past. Exxon-Mobil's P/E is 15, Royal Dutch's 9 and so on-all well below the S&P 500's 19.

The best way to measure energy issues: Look at them as if they are gold or silver mines. Such precious metal operators report the present value of the ore they know they've got in the ground, allowing the market to evaluate the hard cash behind each share.

With that gold standard in mind, we asked John S. Herold, Inc., the oil analyst boutique, to similarly come up with a discounted present cash value of the companies' proven oil and gas reserves. Herold also totes up assets like cash on hand, gas stations, refineries and so on. In arriving at this liquidating value, Herold subtracts an allowance for corporate tax that would be due on a hypothetical asset sale.

Herold's sometimes surprising results are found in the table on page 122. The upper half of the table is devoted to some of the big household names in the business, companies like ExxonMobil and Chevron. The table's lower half covers midsize outfits that don't often get a lot of attention. All these values are calculated based on oil reserves reported on Dec. 31, 2004.

Herold's group of experts has a long and well-deserved reputation as masterful students of the industry. The Herold firm was founded in 1948 by a Yale-trained geologist who went to work in the Oklahoma oilfields right after graduation. Unhappy in that rough-hewn world, John Herold fled back to Connecticut after a short time and set up a consultancy that drilled for numbers in a clean place. Founder Herold, 92, is now retired from the company.

Among big oil companies, ExxonMobil, arguably the world's most consistent and best-run oil firm, stands out as expensive. It is trading at a 22% premium to its putative $45 a share in liquidating value. That $45 is almost evenly split between energy reserves and other assets, like Exxon's $25 billion cash hoard, its refineries and its chemical operations.

Another costly one, oddly, is Royal Dutch Petroleum. (This Dutch side of a famous investment pair was due to be consolidated by the end of June with its British alter ego, Shell Transport & Trading.) Royal Dutch/Shell Group is infamous for the scandal of its overstated reserves, resulting in a management ouster. The chastened company has since cut reported reserves by 25%. So you'd think the firm would trade at a discount. No, sirree. It's trading at a 12% premium.

When Shell announced writedowns for the reserve scandal, these didn't affect the company's cash flow, explains Nicholas Cacchione, Herold's director of research. Plus, a lot of the assets removed from the books will be added back in time, as they become more commercially viable in the coming few years. "I think the market recognized they weren't permanently impaired," he says.

You want bargains? Shares of ConocoPhillips and Chevron trade respectively at a 10% and 14% discount to their liquidating values. ConocoPhillips is perceived as slightly sleepy and also is hurt by turmoil in Venezuela, where it has significant operations.

Chevron has an even richer reserve trove than is reflected by Herold's numbers. These don't account for its acquisition (announced in April) of Unocal for $18 billion, 25% cash and the remainder in stock. Chevron paid $9 a barrel for Unocal's assets, adding 15% to its oil portfolio at a far better price than what it had spent replacing its own reserves in recent years. Chevron stock is off by $10 from its high before the takeover news, a typical devilment for an acquirer. Unocal is down, too, along with oil stocks in general.

The midsize firms are in many ways easier to evaluate. That's because they tend to be mainly drillers and developers, with fewer or no downstream facilities, namely filling stations and chemical plants, to muddy the picture. On the overvalued side of the ledger, the stock of Occidental Petroleum has run ahead of itself and trades at a 20% premium.

Meanwhile, so-so Marathon Oil is trading at a 4% discount, the only company where the downstream assets like refineries are worth more than its oil and gas reserves. Still, a case exists for buying Marathon. If the price for oil and gas should suddenly collapse, the margins in the business will shift toward that end of the business.

The well-run gas specialist Apache trades at a 9% discount, while Pioneer's shares trade at an even sweeter 18% discount to their inherent value. But Pioneer does not have Apache's bottom-line track record. Pioneer was barely profitable in 2002, although it has recovered since.

Probably the best buy of our entire universe is Burlington Resources. Trading at a 15% discount, it is tightly run and one of Herold's favorite stocks. Burlington is concentrated in the U.S. natural gas market, which Cacchione thinks is a better bet than oil. Reason: While most gas consumed in this country is also produced here (unlike oil), there's a gas supply squeeze that should benefit U.S. gas outfits. By Herold's calculations, demand for U.S. natural gas will grow between 1.5% and 2% a year for the next several years, while supplies will increase 1% a year at best.

If you want to pick from a larger universe of stocks, stick to midsize firms focused on exploration and development; these are simpler than complex behemoths like Exxon. Oil and gas players must report in the 10-K footnotes a "standardized measure" of net cash flows (reserve values minus costs), based on proven reserves and discounted at an annual 10% rate.

Use shares outstanding to calculate this cash flow on a per-share basis. Add in values for other assets, such as equity positions and cash piles, while netting out debt and minority interests. Voilà. You've got a present cash value per share to compare to the stock price. Yes, it's not too late for energy stocks. Cheap Energy

Stocks with total values per share (which include reserves) higher than their stock prices are overvalued: Exxon, Royal Dutch, Occidental. The rest are good buys.

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