Big Oil

We have resisted taking a position in big oil for many years for two reasons: (1) None of the integrated oil producers/refiners were producing enough return on investment (ROI) to consistently create value for their shareholders; and (2) The business seemed too volatile, what with oil and natural gas prices bouncing all over the map, and political risks challenging foreign operations, thereby creating questionable risk/reward relationships.

However, things have changed with dwindling domestic oil and gas supplies, $70/bbl (plus) international oil prices, and the prospects of $3 per gallon (plus) gasoline as part of the permanent American life style. Quite simply, this means that the vast in-ground resources and producing assets of the big oil companies are now able to generate the kind of internal return on investment (ROI) that we have to see to interest us as long-term investors. Despite the political risks, which are not likely to ever go away, the value of higher-priced oil and natural gas, and permanently higher gasoline pump prices, have made the integrated oil companies much better long-term investments, in our view.

To add some perspective to our thinking, some analysts are saying that oil will drop to $50/bbl this summer. The oil analyst at Bear Stearns is using a $60/bbl assumption for 2006. However, oil futures are saying something else altogether, with a basing pattern in crude futures predicting a rally above the April high of $75.40. This gives rise to estimates among traders that crude oil will be headed above $100/bbl in the next 12 to 18 months. In any event, the probability that we will be seeing gasoline prices of $3 plus in the next several years, as a norm, seems like about 100% to us, especially when we consider that the Europeans, even countries with their own oil resources like Norway, are paying $5 plus at the pump.

The bottom line? Get used to it, and do something as investors that will allow us to cash in on the situation in the long term. We did our research, ran our valuation model on several integrated oil companies, and decided that ConocoPhillips (COP) is the big oil company we want to own. COP produced 17% ROI against a Weighted Average Cost of Capital of 10.7% in 2005, which nicely meets our EVA requirements, and our model conservatively indicates a valuation in excess of $80. The stock is currently trading in the low $60s, with a one-year forward P/E ratio of 6.5, pays a 2.4% dividend, and has a 12 month trading range between $57.05 and $72.50. Conoco is also using its very substantial free cash flow to aggressively buy back its own stock at these levels; something we really like to see.

ConocoPhillips is one of the largest integrated oil producers and its recent acquisition of Burlington Resources makes it the largest supplier of natural gas in North America. We were also pleased to learn that Warren Buffett has recently acquired a 17.9 million share position in the company (more than 1% of outstanding shares). We don’t always agree with Warren, but we think he is right on his oil and natural gas strategy, especially his choice of COP.

Jack and Peter Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long COP.