Just when Australian individual share market investors began to feel it was safe to come out of the shadows and ponder the possibility of dipping their toes in the water again, along comes Iran.

This surely qualifies as déjà-vu all over again.  Last year worries over dwindling supplies from Libya wreaked havoc on oil prices and this year Iran is playing the same role

The current worry over the price of oil began with concerns over Iran’s work on developing nuclear weapons.  International sanctions contemplated and already imposed have changed the supply side of the oil price equation.  Iran’s threatened closing of the Straits of Hormuz added fuel to the speculative fire, although the presence of the United States Navy may be deterrent enough to keep that tactic from blooming into reality.  Next came .the European Union announcement it would place an embargo on Iranian crude oil starting July 1.  Iran responded by cutting off oil shipments to Britain and France.  And finally, perhaps the largest brick in the latest wall of worry is Israel’s contemplation of a pre-emptive military strike on Iran’s nuclear capability.

Put all this together and you get experts who a few weeks ago were predicting the price of oil would be yet again approaching $150 a barrel as it did shortly before the GFC.  Let’s take a look at how the price of oil has performed over the past 5 years.  The following chart of West Texas Intermediate Crude is from oil-price.net:

As you may know, WTI trades on the New York Mercantile Exchange (NYMEX) and is generally the most followed.  The chart for Brent Crude, traded in London, follows the same pattern.  

WTI went to $109 a barrel in the first week of February and appeared well on its way to $120.  Here is a one month chart for WTI:

Last week US crude futures reached their highest level since May of 2011.  As you can see, prices fell slightly in the last few days.  Some experts expect the rise to resume its upward ride while others now tell us the pullback is due in part to concerns rising oil prices will threaten an already fragile global economy.  So who is likely to be right?

It would be easier to wrestle with that question were it not for the role played by speculators in the oil futures markets.  Speculators have no interest in physical oil as a commodity.  They are not end-users who actually take delivery of a barrel of oil.  To them, oil futures are investment vehicles, just like equities and bonds.  American business news’ sources tell us approximately 70% of the futures trading on the NYMEX is from speculators.  What that tells us is that speculation about where the price of oil will go may be more of a driving force than the real supply and demand of the oil itself.  When speculators sense an opportunity due to a serious supply interruption from Iran, they pile in and the price goes up.  It is demand for the futures contracts themselves, not the oil itself that often causes these spikes.

As an example, Ben LeBrun, an analyst at OptionsExpress in Sydney, attributed the pullback to profit taking from speculators.  When the crowd decides to sell, the price goes down.  However, this analyst expects the price to resume its rise as nothing has changed with the situation in Iran.

While it is hard to deny the role speculative money plays in the oil markets, there is real cause for concern regarding oil supplies from Iran.  Iran accounts for 3% of global oil supplies; making it the second largest OPEC producer, right behind Saudi Arabia.  Iran exports 2.5 million barrels of oil every day, with 500,000 barrels going to Europe.  In contrast, at its peak in February of 2011, Libya was exporting 1.6 million barrels per day.

Saudi Arabia has stepped in and substantially increased its oil exports in the past week.  They have made no official statement, but oil industry insiders see this as their attempt to curb crude prices.  However, history tells us the expectation of supply interruption is a powerful catalyst for rising prices.  Right now, the expectation is for dwindling supply from Iran.  No one knows with certainty how large the shortfall might be and whether it can be made up by the Saudis and others.

Will rising oil prices lead to investing opportunities for Australian investors?  Our top oil producing company is Woodside Petroleum (WPL).  One would expect that higher prices for oil futures should lead to higher prices for the shares of oil producing companies.  Let’s take a look at a one month price movement chart for WPL and another Australian oil producer, Santos (STO) to see what happened:

Investors who bought in as the Iranian news turned grim have seen 6% to 10% gains in a matter of days.  Some of the world’s major oil producers are no longer pure oil plays as they are also involved in gas exploration and production.  Both WPL and STO have substantial assets in gas and that diversification makes them less vulnerable to the volatility of oil prices.  WPL is Australia’s premier player in the highly anticipated development of Liquefied Natural Gas (LNG) and Santos is involved as well.

In the short term, both WPL and STO should benefit from rising oil prices.  However, LNG should make them attractive long term holds.  Another major Australian oil producer that bears watching is BHP Billiton.  While many think of BHP as a mining company, they are in reality a highly diversified natural resources company with assets in a wide variety of endeavors, including oil and gas.  Of these top three Australian oil and gas producers, BHP is by far the most diversified.  As an example of the value of such diversification, let’s compare the five year share price performance of these three companies.  First, let’s look at BHP:

BHP took a beating in the aftermath of the GFC but by the end of the first quarter of 2011 the company’s share price was back to pre-GFC levels.  Investors who bought in during the dark days have reaped substantial benefits.  BHP has shown it has the product and geographic diversification to weather almost any storm.  Now let’s see how WPL and STO have fared:

While all three companies declined in the tough trading year that was 2011, neither Woodside nor Santos came close to regaining their pre-GFC share price going into 2011 as BHP did.  All three are on the rise in 2012, but STO and WPL appear to be benefiting more from the rising price of oil than is BHP.  Given the fact the Iranian situation is not likely to get better anytime soon and could mushroom into a full-blown crisis should Israel attack, are any of these companies worthy of your consideration as long term plays?  First let’s look at some valuation ratios and a few performance measures.

Company P/E P/EG Dividend Yield ROE
BHP 9.48 .75 2.9% 38.2%
STO 26.3 3.83 2.1% 5.1%
WPL 17.58 1.06 3% 13.1%

 

Looking at the combination of a respectable dividend yield, an impressive Return on Equity, and low P/E and P/EG, BHP literally jumps off the screen.  We should point out BHP is classified in the materials sector, not the energy sector.  The average P/E in the Materials sector is 11.88, compared to 21.17 in the Energy Sector.  The Price to Earnings Growth Ratio average in Materials is .65 while it is 1.65 in Energy.

No evaluation of a long term play is complete without looking at historical growth rates.  The idea is simple.  In most cases, companies with solid historical performance are more likely to continue that performance.  In short, performance history points to the potential of a safer share.  Here are five year growth rates in key areas for BHP, STO, and WPL:

Company 5 Year Dividend Growth 5 Year Earnings Growth 5 Year Sales Growth 5 Cash Flow Growth
BHP 14.2% 10.1% 10.7% 16.8%
STO .9% .8% 2.3% .9%
WPL 6.5% 7.4% 6.5% 5%

 

Once again, BHP stands at the front of the line.  What’s not to like about this company?  Right now BHP is trading around $36; $3 up from its 52 week low of $33 and about $14 down from the 52 week high of $49.81.

While BHP appears to be the obvious conservative choice here, there is the risk of economic slowdown in China and elsewhere which would impact BHP’s core business – mining.  For the more risk tolerant investor, don’t overlook WPL.  They are in the forefront of the LNG future and the growth potential there could be enormous.

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