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A Stroll Through the Oil Fields

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Last week we got earnings reports from a number of oil companies and related suppliers. Looking over a few of those reports provides an interesting view of what's going on in the sector. ExxonMobil (XOM), Chevron (CVX), Dresser-Rand (DRC) and Graham Corp. (GHM) all reported last week and those reports combine to provide some good information.

First, the big guys. XOM and CVX both reported earnings that nicely beat the year-ago quarters, but missed analyst estimates. In both cases, earnings from the upstream (oil production) were strong, but the downstream (refining and marketing) earnings were weak (XOM) or a loss (CVX). Both companies also reported lower oil production than a year ago. For CVX the production totals would have increased, but higher prices triggered bigger production shares under some of their contracts outside the US. Both companies reported sizable increases in their exploration and capital budgets; XOM spent $7 billion, up 38% from the same quarter last year; CVX spent $5 billion, up 15.5% from the same quarter last year.

On to DRC. They supply rotating machinery used in the upstream, mid-stream (pipeline) and downstream segments of the oil and gas industry. DRC reported earnings on 30 July. Earnings handily beat analysts expectations and were up over 50% from the same quarter last year when adjusted for some one-time charges in 2007. Revenue grew and beat expectations and the backlog increased by 29% over the past year to more than $2 billion; that's nearly two-thirds of the market cap.

And finally, GHM. GHM supplies heat exchangers, ejectors and other big, heavy stuff to refineries, petrochemical, and process industries. This one is primarily a lesson to CEOs on how to increase a company's share price. Over the course of a little more than one day you:
· Report 38% year-over-year sales growth
· Report earnings that more than doubled year-over-year
· Raise gross margin predictions for the year
· Increase your dividend by 33%
· Announce a stock split

Result? Stock hits a new all-time high with a one-day 15% gain.

Conclusions: Even though the big integrated oil companies are trading at very attractive PE valuations, higher oil prices aren't helping them as much as you might expect. With high prices reducing US gasoline demand, the high crude prices are killing their downstream. XOM and CVX will continue to turn in big profits, but declining production volume along with weak refining business will make it tough for them to beat analyst estimates. I own CVX and don't plan on selling yet; I also don't plan on buying any more here. I did add some to my M* portfolio over the past couple weeks and will trim that back on any strength. No position in XOM.

On the other hand, suppliers to the oil and gas industry are benefiting from those big increases in capital and exploration budgets. It looks like oil companies will struggle to increase, or even maintain, production volume. That means strong business for equipment suppliers, drillers and other oil services. Pick your stocks or you can buy the Oil Services ETF (OIH).

Of the stocks mentioned, I think DRC is the most attractive. It was hammered over the past several weeks and then jumped after the earnings report. It still looks cheap on forward earnings, particularly with the big backlog. For those who think alternative energy will cripple the business; the production processes for most of those fuels still require pumps and compressors. During the conference call, the CEO fielded a few questions and provided some information on carbon sequestration and compressed air stored energy projects DRC is involved in, both of those stand to grow as the focus on green energy increases. I own some DRC and believe it's a good buy under $40 per share.

GHM has been shooting the lights out quarter after quarter for at least a year now, but it's getting expensive (and it may just keep on getting more expensive). I sold a little over half my position (too early) and will hang on to the remaining 'trophy shares' as long as the company keeps performing. No plans to add unless it has a big correction.