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The Petroleum (Integrated) Industry is a mature, cyclical sector that encompasses several business lines. The typical company here conducts oil exploration and development programs, refines and markets oil, and may produce chemicals. The emphasis has long been on the "upstream" end, or exploration, since it generates the highest margins most of the time. Sizable spending is mainly directed overseas, where most oil reserves are found.

Stocks in this industry are most appropriate for investors stressing above-average total return potential over a 3- to 5-year period. There is special suitability for conservative investors, given the solid Financial Strength of many of the companies and the comparative stability of their stock prices. Ties to the business cycle usually mean the industry doesn't perform as well when the economy is in a downturn. But good dividend yields provide downside support.

Margins Depend On Oil Prices

Industry profits and capital spending are broadly determined by the level and direction of oil prices. Factors influencing prices include supply and demand, the futures market, and long-term sector expectations, among other things. Also, the single-largest petroleum supplier, OPEC (Organization of the Petroleum Exporting Countries), carries considerable weight when it makes a decision. The cartel acts as the swing producer in the market. Non-OPEC producers have a harder time adjusting their output, given a lack of spare capacity. Petroleum demand typically ticks up about 1% a year, on average. Down years tend to occur only once in a generation. Most of the increased call for oil comes from up-and-coming nations in the Asia-Pacific region. Demand in Europe and North America is generally flattish, as energy efficiency is emphasized in mature regions to control emissions.

This industry is unique in that geopolitics play a big role. Security concerns in several key oil-producing nations have made it difficult to maximize production. Other countries have taken a go-slow approach to exploration. These factors are a drag on drilling potential, but they support long-term oil prices. Cost inflation can be a problem during boom times. The industry tries to keep expenses under control by ordering bundled packages from oilfield service providers to gain volume discounts. Slack periods often give rise to manpower reductions.

Refining margins also affect the bottom line. Profits from this business, known as the "downstream", are dependent on the strength of demand for gasoline, diesel, and jet fuel. Falling product inventories are a good sign. The close tie between product demand and how the economy is performing illustrates the industry's cyclical nature.

A Tiered Group Structure

This industry contains several of the world's largest companies, some mid-tier players, and a handful of pure refiners. Balance sheets tend to be strong, with moderate amounts of leverage. Most of the international oil giants have assumed modified variations of the integrated business model by lightening up on low-margin refining or economically sensitive chemicals manufacturing. One reason that companies are less eager to own refineries, especially in mature regions, is because the high cost of purchasing crude oil tends to dampen returns. The need to upgrade plant and equipment to meet tightening environmental standards is another deterrent.

Nevertheless, expertise in refining and chemicals can be a plus for companies seeking to gain entry into countries with sizable oil reserves. Many of those nations are in the development stage, and are looking for assistance in building up their downstream activities. Companies able to provide that help may be invited to join profitable joint ventures, and gain an inroad into untapped oil and natural gas resources. Competition is keen to get in on the most promising projects, since there is constant pressure to replace oil reserves at low finding costs, and to ultimately boost production. Over the years, there has been an increased emphasis on natural gas drilling, as costs to ship the fuel by tanker from abroad have come down dramatically, and as fewer large oil discoveries are made. There has also been a revival in domestic natural gas drilling, as new technologies have come into practice. Acquisitions are usually expensive, but can pay off during periods of rising prices.

Valuation Measures

The most common measures used to assess stocks in the group are cash flow and earnings. Cash flow is the more stable of the two, and is used more often near the bottom of the business cycle, when oil stocks are likely to trade at high price-earnings ratios. But cash flow can sometimes mask a high-cost drilling program. Earnings serve as a check on a company's return on its investments and operating performance. Dividend yields are used to determine value, too. Investors often view a stock as inexpensive when its dividend yield is at a historically high level. Oil prices above $50 a barrel provide some assurance that existing dividends will be maintained. Using asset value as a gauge is more difficult, given pricing fluctuations and the varied operating complexity of refineries.

Regulatory Issues

Regulatory issues play a prominent role in shaping industry trends. For instance, in recent years, legislation has been passed in the United States that calls for increased automobile fuel efficiency standards. That will keep a lid on gasoline demand. Climate change legislation could also be a game-changer for refiners and result in a shakeout of industry capacity.