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Considering the worldwide case of the economic jitters and the fluctuations in the price of oil, why would any investor consider shares in the oil exploration and production business?

Simply put, there may be sufficient reward to justify the risk.  The job of the retail investor is to research both reward and risk in accordance with his or her investing style.  Investors with very low risk tolerance would approach a potential investment here with great caution.  Investors with higher risk tolerance should take notice of what the future may hold for this sector.  

In last week’s Sector Scan column here on thebull.com, George Sakellariou, of Investorfirst Securities, offered a bullish outlook for the price of crude oil.  Although he acknowledges the difficulties in forecasting the price of any commodity, he expects to see a 20% rise in the price of oil in the upcoming year and an increase of up to 50% over the next two years.

If you have been reading about the gyrations in the price of oil, you know even the hint of some negative global trend can put the price into a tailspin.  Sakellariou, however, is confident the rising demand for oil in China and India will prevail over short-term market fluctuations

According to him, during the first quarter of 2011, the demand for oil in China rose by 1.2 million barrels a day.  The expectation for the growth in India is 200,000 barrels per day.  He gave a list of shares he believes will do well for investors, assuming a continuing rise in the price of oil.

The list included Australia’s top two oil and gas companies – Woodside Petroleum and Santos Limited – and he is bullish on both.  In his opinion, both are relatively low risk and he sees a potential near term upside of around 20%.

For our analysis this week, we have chosen Santos over Woodside.  Why?  In a word, growth.  

First, if you believe in the Peter Lynch principle that big companies do not make big moves, Woodside’s market cap of 36 billion is about 3 times the size of Santos’s market cap of 12 billion.

Second, Santos recently announced a new oil discovery.  In addition, they state they have the largest area for oil exploration of any company in Australia, including Woodside.  So let us first take a look at Santos Limited (STO), by the numbers.  We will use Woodside (WPL) as a comparison company.

Liquidity and Debt Ratios

Any company involved in oil or mining exploration requires considerable capital to finance these non-revenue producing ventures.  It can be years before a well or a mine evolves from discovery to profitable operation.

For that reason, the amount of debt these companies carry is important, as is their liquidity position.  The following chart compares the two companies on these measures.

  STO WPL Sector
Current Ratio 3.26 .86 .77
Quick Ratio 3.09 .76 .67
Debt to Equity 41.56 42.36 N/A
Long Term Debt (m) 2,787m 4,512m N/A

 

As you may know, a current ratio or quick ratio under 1 means the company could not convert assets into cash in the event of a financial disaster within the current fiscal year.  On these measures, it is obvious that STO is more liquid than WPL.

However, when compared to the Energy Sector averages, WPL’s position does not appear to be cause for concern. 

Debt to Equity measures the level of borrowing capital to invest versus using investor or owner capital.  In both companies, more than half comes from equity, not debt.  Note that STO also carries less long-term debt than WPL, which is probably a function of the size disparity between the two companies.

Profitability Ratios/Dividend Yields

  STO WPL Sector
ROE (Return on Equity) 6.84 15.05 22.55
ROA (Return on Assets) 2.13 6.55 6.76
Dividend Yield 2.4% 2.4% 2.5%

 

On the profitability measures of ROE and ROA, WPL clearly shows a healthier picture.  However, the ROE for both companies is well below the Sector average. 

ROE provides a rough measure of how much shareholders earned for their investment dollar, while ROA how well a company made use of its assets.  Companies heavily involved in exploration activities sometimes show lower ROAs, since assets are committed to operations that have yet to generate revenue.

Both companies pay dividends in line with the overall energy sector. 

Market Valuation Ratios

These ratios tell us how much market participants are wiling to pay for each dollar of earnings (P/E), expected earnings growth P/EG) or book value (P/B). 

  STO WPL Sector
Price to Earnings (P/E) 30.73 23.59  20.32
Price to Earnings Growth (PEG) 1.44  1 1.02
Price to Book (P/B) 1.62  3.08 1.63

 

With a P/E of 30.73, we know investors are willing to pay $30.73 for each dollar of earnings, which qualifies STO as a growth share, though not a particularly outstanding one.  However, the Sector number tells us investors expect growth throughout the sector. 

The PEG ratios are equally bland.  As you know, a PEG of 1.0 means the share is fairly valued.  Ratios significantly under 1.0 or over 1.0 indicate undervalued shares or overvalued shares.

Price to Book is an appropriate measure for companies with significant tangible physical assets.  Again, a higher ratio is an indication market participants are willing to pay more for anticipated growth.  While not spectacular, the P/B of 3.08 for WPL may reflect market anticipation in the growth of their LNG (Liquefied Natural Gas) prospects.  The lower P/B for STO may be a reflection of lower tangible value in assets in the early stages of stgelopment.

Year on Year Performance

Our final comparison will look at the performance increase in percentage terms from 2009 to 2010 for both companies on revenue, net profit after taxes, and earnings per share.  Here are the numbers:

FY2009 vs. FY2010 STO % Change WPL % Change
Revenue ($m) 2% 20.2%
Net Profit after Taxes (NPAT) ($m) 15% 6.9%
Earnings per Share (EPS) cps 15% 2.9%

 

The surprising number here is the negative earnings per share for WPL in 2010.  In contrast, STO turned in a solid, if not spectacular, performance especially considering the relatively modest increase in sales volume.

The final numbers we want to look at are the actual share price movements over the past year.  Here is the one-year chart for our two companies:

#FOTO:1092:400#

In terms of percentage increase in share price, STO had the better year.  What does this all mean?  As George Sakellariou told us, both are solid companies.  However, to dig deeper into the future oil exploration potential of STO, we will have to look behind the numbers.

>>Back to the newsletter to view other articles – June 19th 2011

 

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.