This has not been a good year for oil company stocks. They’ve fallen to the point where many investors now ask if they represent attractive value.
To answer that question, I begin by looking at the price-to-book-value (P/B) ratios of these stocks. Over the course of a business cycle, P/B ratios are better indicators of value for oil and resource companies than price-to-earnings (P/E) ratios, which tend to be misleading. They’re low at cyclical peaks when oil company earnings are high and high at cyclical troughs when oil company earnings are low.
In terms of P/B, many energy shares are now trading well below their historical averages. The accompanying table shows that the P/B ratios of major Canadian oil producers currently vary between 1.1 and 2.6, as opposed to between 1.7 and 3.7 in 2010.
Even in January 2009, at the worst of the 2008-2009 credit crisis, P/B ratios for oil companies were higher than at present. This has led many analysts to conclude that now may be a good time to buy.
But are oil company stocks really cheap? It all depends on one’s outlook for oil prices.
There is a high correlation between oil prices and a portfolio of oil company stocks. Historically, when oil prices rise, so do oil stocks. When oil prices fall, so do energy shares.
Using history as a guide, if you expect oil prices to increase, then investing in oil company stocks is a good idea. If this is your view, oil stocks qualify as value stocks at current prices, because their P/B ratios will revert to the historical mean through an increase in stock prices.
However, if oil prices stagnate or move lower, then these stocks’ P/B ratios give false signals and oil companies are not in value territory.
To get a sense of possible direction of oil prices, one needs to consider the supply and demand for oil. For starters, consider two measures of oil availability – U.S. crude oil inventory and the number of oil rigs in use. Both are the highest in decades, according to Bloomberg BusinessWeek, signifying lots of oil coming down the pipe.
There are no signs of imminent shortages. After many years, global oil supply is now forecast to exceed demand over the next few years according to RBC Capital Markets. Breakthrough innovations in oil extraction can unlock huge supplies of new oil from unlikely spots not only in North America, but also around the globe.
All this is happening while economic activity is forecast to remain weak. So it is very difficult to be optimistic about oil prices, barring runaway inflation, war with Iran or major oil supply disruption due to turmoil in Middle East.
I think oil stocks’ book values are too high in comparison to their prices. The only way that P/B ratios are going to revert to their mean is for book values to decline.
This does not bode well for oil company stocks. Their low P/B ratios are misleadingly giving signals of value. Investors should not fall into this trap.
George Athanassakos is a professor of finance and holds the Ben Graham chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
Price-to-book ratios of major oil producers
|Company||Ticker||Latest P/B||Jan. 1, 2011|
|Cdn. Natural Res.||CNQ-T||1.3||2.3|
Source: George Athanassakos; Bloomberg