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Financial Times: On London: Stable long-term outlook of a cyclical sector

EXTRACT: The big standout exception, however, is oil and gas. The sector has seen a hefty 4.3 per cent share price jump over the past two weeks amid a rise in oil prices and a brief of speculation of a merger of BP and Royal Dutch Shell. However, the sector still trades on a sharp discount to the market.

THE ARTICLE

By Tony Tassell
Published: May 25 2007 19:48 | Last updated: May 25 2007 19:48

The cyclical stock has become a fading species in the UK. It used to be the case that a company that had earnings that rose and fell more with the economic cycle would be valued quite differently to a more defensive stock with more stable profits.

At the peak of the economic and market cycle, cyclicals such airlines would be rated lowly on the expectations that earnings would fall way. At the low point of the cycle, they would trade on high price-to-earnings multiples to reflect a low base of profits and the prospects for improvement.

The more stable defensive stocks such as pharmaceuticals would attract a premium rating for their consistency. There still remains a gap between some defensives and some cyclicals but it has been compressed as the bull market has pushed higher, lifting most sectors.

The big standout exception, however, is oil and gas. The sector has seen a hefty 4.3 per cent share price jump over the past two weeks amid a rise in oil prices and a brief of speculation of a merger of BP and Royal Dutch Shell. However, the sector still trades on a sharp discount to the market.

The sector is rated on a multiple of 11.25 times the consensus forecast for 2007 earnings, according to Thomson Financial. That compares with about 13.6 times for the overall FTSE 100 or 15.4 times for the FTSE 100 excluding resources stocks.

Over the past year, the sector’s share price performance has been almost dead flat. Only three other sectors have performed worse – information technology hardware, healthcare and pharmaceuticals. This is in spite of an oil sector yield of 6 to 7 per cent including share buy-backs.

At first glance, the sector’s low rating maybe justified by the earnings outlook. The consensus forecast for the sector is for a 7.7 per cent decline in earnings this year and a flat performance next year, according to Thomson Financial.

Yet, it is hard not to wonder whether stock market analysts are scrambling to catch up with the surge in oil prices since the start of the year. Brent crude has jumped 40 per cent from a low of $50.75 a barrel in mid-January to above $70 a barrel. Over that time, analysts have become more negative. At the start of the year, they were expecting just under one per cent earnings growth for the sector.

But as Darren Winder, strategist at JPMorgan Cazenove, points out: “What is the greater risk – that forecast market earnings will be downgraded or forecasts for BP will be upgraded. It has to be BP.”

Mr Winder points out that the market multiple for the oil and gas sector compares with a median of 15 times over the last 20 years. Clearly the market is expecting earnings to fall away. Inflation of industry costs may also be a drag on the sector.

However, oil futures markets certainly don’t indicate much of a fall in prices. Brent oil is trading above $67 a barrel for delivery dates as far out as 2012. I am also struck by a research note by Tim Bond of Barclays Capital early this year that made the long-term bull case for oil stocks. He argues that to accommodate the world’s energy ambitions, there needs to be a 50 per cent increase in energy supply over the next 25 years.

In response, markets need to direct capital to the sector through sustained high prices to provide an incentive for producers to increase supply. Mr Bond argues that, while markets may not see an exact reprise of the 1970s when energy scarcity was the dominant market theme, there could be an echo. In that decade, most asset classes in the UK and the US with the exception of commodities and oil offered derisory inflation-adjusted returns.

If Mr Bond is right, as I suspect he is, oil prices will remain high, supporting the oil stocks. The sector, now priced as one of the most cyclical in the market, may in fact, have the most promising and stable long-term outlook.

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Copyright The Financial Times Limited 2007

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