Oil Companies Fueling Pocketbooks

Nihar is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I do not like that my car runs on oil, because gas is so expensive. Despite that oil companies do present good opportunities for strong returns, whether via capital appreciation or dividends. There are lots of factors to keep in mind with oil companies. They are international, because they need to go where the oil is. That adds a political layer to each company. Part of the political layer consists of environmental regulations. These are not just nuisances, but can also cost a lot of money.

Oil exploration is tricky, and requires some luck. That being said, once they strike black gold it can bring in lots of profits. The oil companies I focus on here are so huge that one oilfield is not going to make a huge difference, but large reserves can secure its position into the future, so large fields are important for future profit stability. Expenses need to be controlled in any business, and companies that use technology or other methods to control costs will come out on top.

The industry itself is extremely cyclical and is subjected to its fair share of natural disasters. Oil has a complex supply and demand situation, and it is important to keep track of where oil is going when you take a position in it. You also have to be aware of the physical risks that the companies are subject to. Hurricanes, earthquakes, and political unrest can all affect output. Even the strongest business will be weakened if they cannot get their product to market.

Chevron (NYSE: CVX) recently reported that 3rd quarter earnings would be lower than the previous quarter. The blame is primarily on the hurricane, but a Chevron refinery in California also had a fire and reduced capacity. I think this will be a good entry point for people considering a position in a strong oil company. Chevron could be hit hard when earnings come out. If it slashes forecasts, it will decline further. That creates an opportunity.

Chevron's business looks fine. I do not expect a Q3 earnings hit to tank the company. I will be curious to see if it taps into its massive cash hoard to continue paying the dividend. While it may sound like good business to not pay a dividend, or pay a token one, it would not do much to instill confidence in those investors holding Chevron for the dividends. Dividend investors are not as concerned when a stock stays flat if the dividend checks keep coming. The current dividend is almost 3.5%, and that kind of return per year is not too bad as long as the share price does not fall. Even if the share price rises a little, when you add the dividend it becomes a respectable return. Chevron has enough cash, and debt payments are not a concern, so the dividend will probably be maintained. If the dividend was not going to be maintained, I would like Chevron far less.

Chevron continues to explore new oil fields like all the oil companies. You can look up the various projects yourself, but one example is the Kurdistan deal in Iraq. The thing I am looking at is whether Chevron will have good quarters down the line after it reports Q3. The market recently has punished even meeting targets, or having conservative targets, severely. It seems investors want blowout earnings and absurd levels of growth. Those who keep a level head can profit when the market overreacts.

Petroleo Brasileiro (NYSE: PBR) is the second oil company I like. It used to sport a far better share price. I actually profited from it when it was back around $60 by owning it and writing covered calls, which proved to be lucrative until they were assigned. Getting assigned up in the $60s was great, because it is at $22 now. Despite some lingering issues, Brazil is one of the next oil frontiers. Brazil's reserves are already massive and are expected to increase in the future. There are still discoveries being made.

International exposure is always good to have, but even American oil companies have deals for Brazil's massive oil reserves. Petrobras just has the most access and has the benefit of being a local company. It also has the risk of being a local company. Foreign companies always carry some risk, because the level of regulation and transparency might be different. Corruption is always a concern, but that is true of the United States as well.

Petrobras has strong fundamental metrics, but I do have a few concerns I would want to look into. This is just a preliminary look into the company. Fundamental metrics have to assure me the company is not going to go bankrupt anytime soon, and that opportunities can be capitalized on as they present themselves. Petrobras has plenty of cash on hand, but the profit margin is negative. The negative profit margin is just for one quarter. If this becomes persistent then it could be a problem, but for now it seems fine. Usually the profit margin is between 10% and 20%, which is really good and I will be looking for a positive margin to be achieved again. One quarter is not going to turn me away from a potentially lucrative investment. Free cash flow is very negative, though earnings are positive. Petrobras makes large capital expenditures. The earnings conference call states that the plan is $224B over five years, which came from the question and answer section. The company plans on around $87B in CapEx this year, which is 4 times current cash to put it in perspective. Cash flow will deviate as operations produce more or less revenue. CapEx is a commitment, and the company will make the expenses even if operations fall a bit short in covering 100% of the cost. As long as the investments pay off the negative cash flow is acceptable. Only time will tell if the investments will be good ones.

The book value per share is much higher than the current share price, but I would not jump on the undervalued bandwagon. It trades at a discount because of all the risks involved. One of the risks is how expensive the Real is. I do not want to get into foreign exchange here, but an expensive currency is bad when you plan on exporting something like oil. The economic slowdowns in the US and Europe have hurt the global oil market, which highlights another risk in oil. All that being said, Petrobras seems like a solid company. If you want a piece of Brazilian oil, then I think Petrobras is the way to go. This stock is for the long term investor, however. I think its value will materialize over the next decade, with at least 2 years before the current slump turns into a strong uptrend.

Conclusion

There is a lot I do not understand about the oil industry, though I do not need to know the scientific details to know that it is important to our society and our economy. Both the companies above are good, but Chevron is the safer one if you wait to see if it suffers due to its weak Q3.

Petrobras is for the more adventurous, but it could be one of the biggest oil companies in the world. It might take a while for Brazil to really start exporting a lot of oil. The waiting game might help maximize their profits as oil gets more and more expensive. Then again, a glut of Brazilian oil might bring down prices or at least prevent them from climbing. The oil is there in Brazil, and it is enough to be a big deal. Petrobras is probably the best suited to benefit from it, but nothing is certain. That is why it is the riskier investment.


TheArchivist has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Chevron and Petroleo Brasileiro S.A. (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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