Crude Math

You can be your own OPEC! Okay, maybe that’s a little glib, but it sure beats the notion that I hear every day: that the rising price of oil is a no-win situation for American investors. You can, even after the tremendous run that crude has had, make a fortune owning a portfolio of oil and oil-related stocks. You can do so because everyone, from the analysts on Wall Street to the oil executives on Main Street, is simply way too bearish on the fundamentals of the petroleum industry.When I got into the stock-picking business 25 years ago, oil stocks dominated every portfolio I reviewed. The “complex,” as we knew it then, represented more than 20 percent of the S&P 500, and most analysts thought oil, which was at $30, would swiftly head to $50 and then $100. The execs at the companies sure felt that way, too. They spent the next five years overbidding on projects, both deep-water and alternative-energy, that cost their companies billions.

Of course, we all know what happened. Oil plummeted to $10 or so a barrel, and other than a sharp spike fifteen years ago after Iraq invaded Kuwait, it’s pretty much run in place. Those uneconomic projects almost destroyed most of the companies involved and created lots of bad will with portfolio managers. The era of brands, finance, and tech soon eclipsed hard assets, and the oil sector dwindled to as low as 5 percent of the S&P two years ago.

Now oil—the crude—has made a monster comeback, almost double where it was last year. But the stocks, while strong, haven’t nearly followed suit. That’s because the people who matter in oil—the corporate executives and the OPEC ministers—didn’t see the rally coming and are still in denial. The OPEC gasbags keep talking about increasing production, but they can’t: They’re pumping full-out now. The top dogs at the oil companies don’t believe in the sustainability of these prices, not for one minute. They talk knowingly about how crude must come down any day now, and they remain oblivious to the ever-rising ramp-up of prices. That’s because the highest-level execs at almost every major oil company are the same people who recommended the outrageously expensive bids to their bosses in the early eighties. These once-burned-twice-shy execs haven’t even bothered to increase their oil-exploration budgets because many of them think that oil will soon be back to $30 a barrel.

They are totally wrong. They are wrong because it isn’t the supply side that’s causing the shortage. It’s the demand side: China and India are using oil the way the United States used to use oil when it seemed abundant. They are both gas-guzzling nations that can’t even begin to conserve because their economies are developing so fast. And China loves a good Buick—we’ve exported some of our gas-thirstiest models, and they’re being snapped up as fast as we can make them.

Of course, it doesn’t help that oil comes from only the darnedest, most dangerous places: Russia, Nigeria, Iraq, Iran, Indonesia, and Myanmar are the best hopes for increased production. Most of the majors, and their attendant skilled workforces, are afraid to drill in these venues, for fear of either nationalization or terrorism. Nor does it help that the president’s energy policy is totally laughable. Let’s face it: We are nowhere when it comes to finding more oil, in terms of conservation or in alternatives (forget the Arctic National Wildlife Refuge; it’s a drop in the bucket and will take years to tap). I wouldn’t be surprised if oil kept climbing all year and if $65 a barrel is in the cards. People want more and more of it, and we simply don’t have enough to go around.

So, we can bellyache about the long-term shortage, or we can profit from it. I’m a profit kind of guy. Here’s what I own or would buy to play the coming rise in oil. I’m picking stocks that haven’t fully benefited from the increase and sell at discounts in part because of extenuating circumstances, and in part because Wall Street still can’t get over the eighties.

Oil has made a monster comeback, almost double where it was last year. But the stocks haven’t followed suit.

First, you need to own at least one integrated oil, a company that explores, pipes, refines, and markets oil and gasoline. All these companies tend to trade roughly together, even though they shouldn’t. If you think that oil’s going to $65, as I do, you want to own the integrated that’s most levered to oil prices: ConocoPhillips. It’s a well-run machine that stands to benefit from whatever drilling might occur in ANWR. Unfortunately, it sells for more than $100 a share, a turnoff for most retail investors. If you want a little more caution, pick up some ChevronTexaco, a high-yielding company that just now is wresting the synergies from its big merger. If oil scares you to death as an investment, but you want to heed my view, buy ExxonMobil. With $23 billion in cash, very big buyback, and nice conservative accounting, it’s the “bank” of the group.

Second, you need a Canadian play. With oil above $40, Canada’s a North American Saudi Arabia, with lots of oil that’s hard to get (it has to be squeezed out of rocks) but suddenly worth getting. I like EnCana because it has the best replenishment rates (it finds a lot of oil) and has some of the most unexplored acreage on the continent.

Third, you want a refiner. For years, the environmentalists have stopped construction of refineries in this country, and I don’t expect a new one to be built anytime soon. That makes Valero, one of the nation’s largest independent refiners, a huge buy. Don’t be put off by the doubling this stock has had; it could double again and still not be expensive. It probably will, as we are way short of refining capacity.

Fourth, you need an old-fashioned wildcatter, a company that can take advantage of the oil we still have in the ground in the United States. We have only a few independents left of any consequence—Ultra Pete, XTO, and Cimarex. I like the last because it made an acquisition recently of Magnum Hunter using its own stock. Pressure from arbitrageurs who are selling Cimarex to buy Magnum will soon subside, and the stock of this high-quality explorer could be off to the races.

Finally, you can’t think about oil without thinking about Halliburton, the least politically correct stock in the universe. Owning this stock before the presidential election was like carrying around nitro in a pickup truck on an old dirt road. Since then, the headline risk has diminished, but most managers are still scared to take a swing at the cheapest driller out there. HAL recently put to rest its asbestos woes, opting not to wait for congressional action. Smart; now none’s forthcoming. There’s talk that it might split into a drilling company and a construction company. The sum of these parts is worth mid-50s; buying it before the split makes an immense amount of sense.

Every time I think that the oil move’s been made, I talk to money managers who have no exposure to the group. Resistance to owning oil remains way too high. I would buy this package of five and own the stocks until oil represents more than 10 percent of the S&P, half of what it used to be and still well above where we are now—8.5 percent. Only then would oil on Wall Street be worth what’s left of the oil in the ground.

James J. Cramer is co-founder of He often buys and sells securities that are the subject of his columns and articles, both before and after they are published, and the positions he takes may change at any time. At the time of this writing, he owned Halliburton Company, Cimarex Energy Co., and EnCana Corporation. E-mail: jjcletters at thestreet dot com.

Crude Math