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Why Your Oil Stocks Aren't Making You Rich

By Matt Badiali, editor, S&A Resource Report
Thursday, December 6, 2007

"Why didn't ConocoPhillips double this year?"

The question came from an exasperated subscriber at the Stansberry Research Alliance Conference in Playa del Carmen, Mexico, last week.

It's a good question. Some big government-backed oil companies – like Brazil's Petrobras and China's Petrochina – did double last year. However, your average supermajor oil stock (ExxonMobil, ConocoPhillips, British Petroleum, and Chevron) has only managed to gain 15%, while crude has soared 42% in the same time.

So what's holding the big guys back? It certainly isn't the price they receive for their oil... It's the simple fact that the cost of finding more oil is skyrocketing.

In fact, it now costs ExxonMobil $14.57 to add a single barrel of oil to its reserves. That's nearly double what it cost in 2003.

This week, the Financial Times ran an article that quoted research by Wood Mackenzie analysts. Due to the rising costs of skilled labor, licenses, and equipment, exploration companies need an oil price of $70 oil to earn the same amount of money that $30 oil generated just two years ago. Think about that... oil companies need 140% higher oil prices just to maintain their earnings.

You can see this cost inflation in the annual reports of the world's top oil service companies. Take the biggest, Schlumberger, for instance. Schlumberger's operating income rose 518% from 2003 to 2006. The world's biggest deepwater drillship operator, Transocean, has enjoyed an operating income increase of 428% over the same period.

Profit margins are also soaring for oil service providers. Look at the increase in operating margin for Schlumberger and Transocean over the past four years:

Operating Margin

Back when oil sold for less than $20 per barrel, the oil service industry was lean. The competition among service companies reduced operating margins to single digits, for the most part.

Now that oil is hitting historic highs, operating margins are rising in nearly every facet of the oil industry, including offshore drilling, well completion, pipeline services, refinery construction, seismic mapping, and platform building. And this business doesn't expand capacity like a real estate brokerage. Oil exploration is technically challenging and requires extraordinary computing power. Success in finding oil requires the services provided by a few, specialized companies.

As a result, the supermajors' margins are narrowing, while giant service companies' margins are growing.

I think this trend will last for years, so the obvious conclusion here is to buy oil service companies The S&P Oil & Gas Equipment & Services (XES), PowerShares Oil & Gas Services (PXJ) and Oil Services HOLDRs (OIH) are a few ETFs that hold the biggest and best in this industry.

I'm still a huge fan of Schlumberger. We bought Schlumberger in the S&A Oil Report about a year and a half ago, and we're up 52% already. I think it's a great one to own for the long term.

Don't misunderstand me. I don't think you should run out and sell your ConocoPhillips shares. Owning supermajors remains a safe, dividend-paying way to profit from high oil prices. However, with the high operating margins the services industry has right now, I expect these companies to continue to outperform the majors in the short term.

The famed investor Jim Rogers once said if oil reaches $150 a barrel, they'll be drilling for it on the front lawn of the White House. That could happen – if they can find the equipment. 

Good investing,

Matt Badiali

Market Notes


The joke goes like this: An old farmer is asked what he'd do if he hit the lottery for $10 million. He thinks for a moment and replies, "I reckon I'd just keep on farming 'til it was all gone..."

The joke is born of the notoriously difficult and unprofitable profession of dirt farming. One has to battle the weather, volatile grain prices, taxes, pests, and broken machinery just to keep from going broke in this business. Thankfully, the American farmer has the hungry people of Asia and the ethanol boondoggle on his side these days...

We've covered shares of fertilizer, farm equipment, and seed producing stocks in the pages as plays on rising food prices. Today, we present an ETF that goes right to the source: The PowerShares Agriculture Fund (DBA). This fund uses the futures market to create a diversified position in corn, soybeans, wheat, and sugar... all of which are running to the upper right of their price charts. We described the fund's creation in January.

We can wholeheartedly recommend this ETF for the folks who worry about global warming, global cooling, droughts, floods, and tidal waves. We have a heck of a time keeping up with the fashionable catastrophe of the hour, but we're sure any of them are bullish for grain.

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