My latest column is up at RealMoney.

With oil dictating everything in this market, I can’t understand why ConocoPhillips (COP) is trading at 7 times next year’s earnings.

It’s not like the earnings estimates are falling. 90 days ago, analysts expected the company to earn $10.43 a share this year and $10.59 next year. Today, the estimates are $12.41 and $13.44, respectively. The consensus five-year growth rate is just 1%, which would mean a drop back to $7.65 a share within five years. I just don’t see that happening, so there should be potential upside surprise to the growth estimates as well.

It’s not the earnings quality, either — at least not as measured by the accrual ratio. That ratio shows that Conoco’s accounting-based earnings are within 3% of its cash-based earnings. At BP (BP - Annual Report) , the difference is 99%. Suncor Energy (SU - Annual Report) has a 50% accrual ratio. For Petrobras (PBR) , it’s a whopping 122%. I’ll take Conoco’s tight relationship between earnings and cash flow any day.

Speaking of cash flow, Conoco has just loads of it. Over the last 12 months, the company’s free cash flow (cash flow from operating activities less capital expenditures) was $12 billion. Cash from operations has been growing steadily, suggesting that the free cash flow may improve further. With Conoco’s $145 billion market capitalization, that amounts to a free cash flow yield of 8.3%. The 500-basis-point premium over Treasuries is a pretty attractive risk premium, even if the cash flow doesn’t grow. Among the integrated oil names, only Total Fina (TOT) has a higher free cash flow yield.

ExxonMobil (XOM - Annual Report) looks pretty good — its free-cash-flow yield is nearly as high as Conoco’s, and its earnings quality is equally robust. Its earnings estimates are rising as well, though not by as much as Conoco’s. Yet even though it’s got less earnings momentum, it is trading at a higher P/E of 9 times next year’s estimate.

I think Conoco’s growth rate will be more like 4% or 5% annually over the next five years, and that its price-to-book could expand to at least 2.0 times over the same time frame. By my calculations, that scenario would result in an average annual total return of 17% to 20% a year.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned in this article.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Large Cap Watch List (Track at Marketocracy).

Though less than the Small Cap Watch List and Mid Cap Watch List (Track at Marketocracy), there was still relatively high turnover in this list. 14 of the original 33 names made the cut for the new list (which was trimmed to just 26 names.) Part of the reason for the turnover was to reduce overlap between the lists. One third of the Mid Cap Watch List (Track at Marketocracy) names appear on each of the Small Cap and Large Cap Watch List (Track at Marketocracy)s, but there is no longer any overlap between small and large.
So without further ado, the names on the chopping block from the previous list are:

3M (MMM); Continental (CTTAY.PK); Mitsui (MITSY); Anheuser-Busch (BUD); ConocoPhillips (COP); Helix Energy (HELX); IndyMac Bancorp (NDE - Annual Report); Barr Pharmaceutical (BRL - Annual Report); Quest Diagnostics (DGX); Public Storage (PSA); ITT Educational Services (ESI); Equifax (EFX); Rent-a-Center (RCII); Kroger (KR); Ricoh (RICOY); First Data Corp. (FDC); Expeditors International (EXPD); and Keyspan (KSE).

The new list is:

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Large Cap Watch List (Track at Marketocracy) (to be measured against the S&P 500) follows.

Astute observers will notice less overlap between this watch list and the names in the Small Cap Watch List and Mid Cap Watch List. This was not for lack of overlap, as the smallest S&P 500 name has a market capitalization of $600 million, which would allow for complete overlap with the Mid Caps if we chose. Instead we selected an arbitrary low of $2 billion for large-cap names, which cuts off five names that are actually in the S&P 500.
In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.

Despite plummeting prices for oil in recent weeks, we still don’t buy the bear case, which calls for a slower economy to rein in prices. The problem is, in the 1974, 1981, 1991 and 2001 recessions that failed to happen. We don’t see why it would this time. Meanwhile, the weakness is all about the pleasant weather we’ve been having.

Oil & Gas Journal - MARKET WATCHEnergy prices fall as warm weather continues

“Weather continues to be the name of the game, as crude oil prices continue their slide from yesterday in early morning trades today,” analysts in the Houston office of Raymond James & Associates Inc. said Jan. 4.”That said, the latest 2-week weather forecast for the US shows cold weather beginning to set into the Lower 48 states by the latter half of the month, and natural gas has rallied on the news in early morning trading. However, a warm winter till now has prompted us to take a more cautious stance on winter-ending natural gas storage and near-term North American drilling activity,” the analysts said.

The thing is, weather fluctuates. And while the weather has been far warmer than normal inventories remain well below their historic average iin terms of days of supply. What will happen when normal weather resumes?

Barry Ritholtz recently expressed his dissatisfaction with the explanations being bandied about in the media as to why oil prices have fallen:

Here is a short list of the most common current explanations circulating in MSM:

1. More Supply coming online;
2. Reduction of global terror threat;
3. Cooling of hostilities between Israel and Lebanon
4. Seasonally weak demand, as Hurricaine season ends;
5. Iran cooling inflammatory rhetoric

I find these some of the mainstream explanations unsatisfying. At the risk of creating a strawman (only to knock it down), let me put forth my top 5 list:

1. Fast money rotating out of commodities and into tech;
2. Cooling economy consuming less energy;
3. No major supply disruption from weather or Middle East;
4. Psychology peaked earlier in year; (see Business Week Cover Story)
5. Stretched consumer shifts behavior;
6. And lastly, the Weak Strong US Dollar (Crude is priced in greenbacks)

We agree with Barry that each of these can pretty easily be explained away, as we do here:

1. Supply coming on line takes years. What new supply could have come on line that was not anticipated three months ago?
2. Just because they will let you take some of the liquids back on the plane now doesn’t mean the terror threat is any lower.
3. Israel and Lebanon don’t exactly have much oil - no oil supply was disrupted during their skirmish and it did not create any particularly unusual demand, so why would it have any effect on price (which was rising for years before the skirmish started?)
4. Seasonality is a valid point but certainly a very temporary one. It is long-term supply/demand balances that sent oil to $78, and those haven’t changed.
5. Iran? Isn’t this sort of the terror/Israel arguments tied together? Iran either wants to sell oil or it doesn’t. We’re betting on the former and think they are selling as much (or nearly so) as they can produce and that this won’t change any time soon.
6. Amaranth certainly suggests there was some speculation on the way up, but also suggests that (post their pop) there may be limited downside remaining.
7. The economy would have to cool to zero percent growth for the next five years for technology and substitution to offset the normal demand increase attributable to growth. If that is your forecast, fine (although I hope you are wrong.) Otherwise, your outlook for oil should be consistent with your economic outlook.
8. Psychology? Perhaps it had an impact on price, but it sure doesn’t affect supply or demand much. Unless you can quantify the impact on price, how do you know the current price is any more correct than last month’s?
9. Stretched consumer: See #6 above.
10. Dollar: Ditto.

So with the easy explanations as easily tossed aside, how about something with more meat? John Mauldin recently reposted a Charles Gave article on his site. Its basic tenet that oil prices will be brought back down due to substitution and new technology is beyond reproach. As far as the timing, however, we found it to be long on optimism and short on consistency. Consider:

1- The return of king coal: In WWII, the Germans (who were long coal and short oil) refined processes to make gasoline out of coal. This old process has been perfected and is now a source of energy in South Africa. Why is this important? Because there is more coal in North America or Australia than there is oil in the Middle East. The problems in using coal have historically been a) ecological issues (which can be solved with some money) and b) costs (using/moving coal is not as economic as low oil prices).

2- The exploitation of tar sands or bituminous coals in Canada, the US, and yes, Venezuela. Here, once again, the technology exists and the extraction costs are roughly US$30/bl. The production build-time is roughly around three to four years. The big hang-up is the shortage of technicians. Such shortage problems can however be solved after a few years (time of schooling/training) or, by enticing retired technicians to come back.

The company that converts South Africa’s coal into fuel is Sasol (SSL) and is on our Watch List. During the last few months they have not opened vast new capacity, nor even announced plans to start building vast new capacity. In fact, the recent decline in oil prices has hit Sasol and the tar sands producers harder than it hit traditional suppliers because these processes are only profitable when oil prices are as high as they have been recently. Given the long lead times for building the plants and extracting these resources, companies naturally want some degree of comfort that the price will not fall significantly below current levels for some time. The recent price decline reminded them why they did not start building these plants five years ago, and is unlikely to encourage them to start building them now.

The article continues:

3- The emergence of new technologies to recover more oil out of old and decaying oil fields. With the price of oil where it is, it makes a lot of sense to invest substantially to try and optimize the output from any individual well. In the past 25 years, we have seen the average extraction at existing wells climb, thanks to technology, from 25% of known reserves to 40% of reserves. Norway has set a target of 65% to 70% recovery for a good part of its reserves and is already achieving that in some fields. Where do the improvements come from? Technological progress!

Once again, technological progress that has not occurred overnight. If it took 25 years to increase extraction to 40% it is likely to take as long for it to reach 65%.

4- The possibility to produce oil/ethanol out of agricultural products. On this very topic, the best summary we have read of the issues at hand was produced recently by our friend Mark Anderson, the editor of the SNS newsletter. We lift his work below shamelessly: “Ethanol is a liquid fuel, currently produced from corn… Now here’s the rub: there is a debate about whether it actually takes more energy to create a gallon of ethanol than the energy contained in a gallon of ethanol. According to Report No. 814 from the Office of the Chief Economist of the U.S. Department of Agriculture, corn ethanol contains 1.34 times the energy required to manufacture it….

There are longer-term solutions. In a period of about five years, we could be producing ethanol in quantity from cellulose. Cellulose is found in a variety of plant material, including the stalks of the corn plant. The process for production of ethanol from cellulose does not require large amounts of hydrocarbons and is, therefore, much less expensive. If the federal government continues to provide large subsidies for corn-derived ethanol, however, we are in effect providing a disincentive to make capital investment in cellulose technology. The corn lobby will fight tooth and nail, but in the end, democracy, just like the free market, has a way of doing what is right and sensible (usually, after trying out all other options). In this case, that would see cellulose derived ethanol become widely available in the marketplace.

Well, call us in five years when the cellulose plants are up and running. In the meantime, with a 1.34 energy output/input ratio the best ethanol can do is cut fuel consumption 34% - and that is assuming there is that much excess corn produced, that the plants can be built, that the increased demand for corn doesn’t make it even less profitable, and so on.

6- Prices & Substitution

High energy costs are not impacting just oil. We have witnessed a stupendous rise in the price of all forms of energy through the substitution effect. And here technology is also making huge leaps. Let us, again, go through a few examples:

* Nuclear power. There are two main problems with nuclear plants. The first is that building a plant takes a long time (though the Chinese are definitely not wasting any time on that issue). The second issue is the disposal of the nuclear waste. But this is where the exciting news lies: we have recently read reports highlighting that the volume of the waste in the new French reactors is a tenth of what it was in the old reactors. This implies that the amount of space needed to store the waste is much smaller, and the arguments of the anti-nuclear green lobby further reduced.

* Production of energy at the individual and local levels: everywhere we go, especially in Europe (where the price of energy, on top of being very high, is also heavily taxed), we find new and interesting forms of energy production: in Scandinavia geothermal energy (one drills in the rocks, and gets the heat coming from below); in France, a massive movement towards heating pumps (exchanging heat between a source of water and the atmosphere - in fact, after a brutally hot summer in Provence, I am biting the bullet and having such a system installed in my Avignon house); in Denmark, there are quite a lot of wind turbines; in Spain, you can see solar panels on a growing number of roofs. All these systems enjoy huge tax breaks, and, once they are put in, they are here to stay; markets lost for oil, for ever.

By themselves, none of the above factors is sufficient. And the rate of substitution from oil to these new sources of energy is excruciatingly slow. For example, if one had the bad luck of installing an oil boiler in one’s house three years ago, one is not going to change now. The capital costs are simply too high. But taken together they are significant and will change for ever the demand for oil or natural gas used to heat or cool houses, factories, or office buildings.

This is indeed the meat of the article, but there is nothing to say that this can happen any time soon. With a ten-year lead time to build nuclear plants, we just don’t see it making a sizable dent any time soon. Then, apart from the environmental issues, Gave offers the reason why it may not help even then:

Our 19th century world was dominated by coal. Our 20th century was dominated by oil. It is our firm belief that the 21st century will not be dominated by oil. It will be dominated by electricity; and oil will become a marginal energy. This simple truth might help explain why, since 2001, uranium has not had a single down month, and since 2003, uranium has never traded down for even a single day, regardless of what was happening to oil prices.

With uranium prices rising so much, why even bother? It sounds like it won’t do much to make energy cheaper, which is after all the point. In fact, there may not even be enough uranium out there to support much additional demand. As far as substitution consider that the median age of vehicles in the US is 9 years. If you assume that hybrids improve fuel efficiency by 50% over their gas-only counterparts, even if 100% of new car sales were hybrids it would take 18 years to fully replace the vehicle fleet and reduce fuel consumption by 50% overall (assuming demand doesn’t continue to rise.) Based on a more realistic (but still wildly agressive relative to today’s sales levels) assumption that 10% of new vehicle sales will be hybrids, the annual demand reduction is less than 0.3%. Color us unimpressed.

With that off our chest, some stories affecting individual companies recently:

Statoil STO) strikes gas at Barents Sea Well

Pension and endowment funds aren’t giving up on commodities yet.

ConocoPhillips Confirms North Sea Discovery - Oil and Gas Online

Helix names new CEO

Disclosure: Author owns shares of United States Oil Fund (USO).

William Trent currently has a short position in put options related to Office Depot (ODP).

We originally wrote this post in response to a comment on one of our recent articles.

There is no doubt that businesses have tried to become more efficient in the last 20 years, and not carrying excess inventory is a part of that. Ask Ford if high days of inventories is a good thing. We agree that days inventory have not been a predictor of prices over the last 20 years. We do contend, however, that looking at total supply in barrels (rather than days of supply) as some of the bears were doing is an incorrect metric for considering supply/demand balance.

Our belief is that the long-term trend of shrinking inventories was due to the fact that holding oil during that time was a money-losing proposition. As oil prices fell producers, wholesalers and retailers were more willing to hold less inventory, as holding the inventory presented both storage costs and the potential that prices would decline further. For the same reason, companies also underinvested in finding new sources - whether they be new oil fields or alternative sources - there was no business incentive to do so.

Even now, with oil in the range of $70 per barrel, alternative energy sources have major drawbacks. To make a tank of ethanol deprives the world of enough food to feed someone for a year. So in addition to the actual cost there is an opportunity cost that makes ethanol effectively cost something like $350 per tank. Solar? MIT’s Technology Review talks to the inventor of the most efficient solar cell, who says:

A very reputable journal [Photon Consulting] just published predictions for module prices for silicon for the next 10 years, and they go up the first few years. In 10 years, they still will be above three dollars, and that’s not competitive.

Yes, people are trying to make silicon in a different way, but there’s another issue: energy payback. It takes a lot of energy to make silicon out of sand, because sand is very stable. If you want to sustain growth at 40-50 percent, and it takes four or five years to pay all of the energy back [from the solar cells], then all of the energy the silicon cells produce, and more, will be used to fuel the growth.

And mankind doesn’t gain anything. Actually, there’s a negative balance. If the technology needs a long payback, then it will deplete the world of energy resources. Unless you can bring that payback time down to where it is with dye-cells and thin-film cells, then you cannot sustain that big growth. And if you cannot sustain that growth, then the whole technology cannot make a contribution.

With regard to the dye-cells [he invented], silicon has a much higher efficiency; it’s about twice [as much]. But when it comes to real pickup of solar power, our cell has two advantages: it picks up [light] earlier in the morning and later in the evening. And also the temperature effect isn’t there–our cell is as efficient at 65 degrees [Celsius] as it is at 25 degrees, and silicon loses about 20 percent, at least.

If you put all of this together, silicon still has an advantage, but maybe a 20 or 30 percent advantage, not a factor of two. [Meanwhile] a factor of 4 or 5 [lower cost than silicon] is realistic. If it’s building integrated, you get additional advantages because, say you have glass, and replace it [with our cells], you would have had the glass cost anyway.

So realistic solar cell production that are cost-effective without subsidies are still a few years away. In the meantime, we’ll have to dig deeper and deeper for new energy sources.

Meanwhile, demand continues its steady upward march. The last five years have been the wake-up call, saying “Hey, you need some new energy capacity.” Now higher prices are starting to provide the business incentive but it will take years for the new supplies to make it to market. Eventually they will, and when they do they will come in large numbers just as consumers have started switching en masse to more energy-efficient products and prices will plummet for 20 years. That’s the way the free market tends to work in the commodities business.

But for now - we expect higher prices. In the interest of fairness, though, here is the other side: Forbes has the case for oil going to $45. But the Forbes pundit once again says “inventories are at record levels” when justifying his belief - we reiterate that the amount of inventory is only relevant in the context of how much is being used. And while that number too is rising for now, it is at least 20% below record levels.

On Friday, oil prices continued their downward movement. With two large finds announced this week, resumption of service at BP’s Prudhoe Bay pipeline, and the end of the summer driving/air conditioning season the commodity is taking a bit of a breather. Already down on the notion that a global economic slowdown would curtail demand, the latest knocks have broken important technical resistance levels (see chart for oil ETF below.) Is the commodity bull run now officially over?

We don’t think so. We aren’t believers in oil for seasonal reasons, or on the basis of supply disruptions, or even for technical reasons. We believe oil will continue to rise because capacity is nearly fully utilized, demand will continue to rise (even if interrupted briefly by an economic slowdown) and because it is hard to find and utilize new energy sources, whether they be new oil reserves, oil sands or even alternative energies. These sources will not replace five percent of world demand overnight, but with global demand rising at roughly five percent every year that is what would be needed to get oil prices down for an extended period.

Maybe it’s just a function of T Theory, which states that a bull run will last as long as the preceding “rest” period - in this case oil has had a 20+ year rest period, so the bull run should still have legs if the theory holds. Or maybe it’s an Elliot Wave type of event. Or perhaps it falls on behavioral patterns - the long period of low oil prices led to underinvestment that will not be reversed for a long period of time. Whatever theory you want to point to for explanation, we just think oil will generally go up for the foreseeable future.
The action last week was starting to get nonsensical. Take Conoco Phillips (COP) for example. On Friday they announced a major gas find in the North Sea adjacent to one they are already exploiting. However, the shares fell nearly 2%. It’s not like the new find will be the straw that breaks the oil camel’s back and floods the world with supply. It will take years to exploit the find and it will barely affect total energy supply when it is up and running. But for Conoco it has a more meaningful impact, and not the type that should send the shares down.

As to the rise in inventory, there was one. For total crude products, there are now 50.4 days of supply, up from 50.0 days last week (see chart.) We are even flirting with the long-term downtrend line again, potentially signalling that we are wrong and that the world (or at least the US) truly is awash in oil (the two gas stations we tried today, both being out of regular gas, tell another story). But we are also still 10% below the average inventory level of the last 15 years, and well below the levels in 1990.

During the stock market run of the 1980’s and 1990’s the common advice was to buy the dips. During the commodity run of the 2000’s and 2010’s that is our advice for investors in oil.

The latest EIA data shows that inventories continue to build modestly. Days inventory remains below the long-term average but increased slightly from the previous week and may be at a critical technical juncture. Continued growth in days inventory will result in a breakout from the recent downward trend. A pullback could indicate that the short-term rising trend will be as illusory as that of the late 1990’s.

Meanwhile, the PPI data showed that refining costs are rising at a 45% pace year/year and remain in a rising trend.
And oil drilling equipment is also getting more expensive:

Over the weekend, the New York Times published an article exploring whether there would be more mergers and acquisitions among drilling companies following Anadarko’s double-takeover of Kerr-McGee and Western Gas Resources. The article says: More »

Last week we took issue with the idea that higher absolute inventories of oil products in the US suggest oil prices should be lower, arguing that it was the number of days’ demand that the inventories could supply that was the more relevant number.

Jay Walker hit on the other major reason that US inventories should not have the predictive power they once might have: increased demand from India and China. He points to a New York Times article that makes the following points about China:

• Total miles of highway, now some 23,000, more than doubling what existed just six years ago;
• Year over year growth of car sales of 54%;
• Passenger cars on the road, now 20 million, compared to about 6 million in 2000;
• Government announced target of 56,000 miles of freeway by 2035 (the US has 46,000 miles of interstate highways);
• and by 2030 carbon dioxide emissions are projected to exceed those of the US.

Walker goes on to make his own point, with which we heartily agree:

Anyone who thinks that the demand for global fossil fuels will abate anytime soon, should also consider that the average American uses about 25 barrels of oil annually, versus 1.8 barrels in China and 0.8 in India. Those latter two figures are obviously going to move upwards at a rapid rate, considering those countries recent growth rates in the 7-10% range annually and the apparent embedding of the car culture in China particularly.

Which of course provides a long tailwind to investing in the fossil fuel industry.

And, of course, alternative energy sources. Last week we chuckled at calling coal an “alternative energy” but now we read that Watch List member Sasol (SSL), which has long converted coal into traditional liquid fuels, is going a step further and converting it into hydrogen for fuel cells. More »

Indonesia sees crude output rising to 80,000 barrels a day by 2008 - MarketWatch

Indonesia’s crude oil output will rise by 80,000 barrels a day by the end of 2008, Kardaya Warnika, chairman of upstream oil and gas regulatory agency BP Migas, said Friday. That increase will include 50,000 b/d from Chevron Corp.’s (CVX - Annual Report) North Duri field in South Sumatra province and an additional 20,000 b/d from the Conocophillips (COP)-operated offshore Bukit Tua field in Madura province, Warnika told reporters.An additional 10,000 b/d of new production in 2008 will come from Madura’s Ujung Pangkah field, he said, without elaborating.

Indonesia current total crude oil output currently averages 950,000 b/d. Indonesia, Southeast Asia’s sole member of the Organization of Petroleum Exporting Countries, was a net oil importer in 2005 due to faltering investment in oil exploration and development.

ConocoPhillips raises production target and guidance:

U.S. oil major ConocoPhillips on Thursday said it expects production in the second quarter to be about 30 percent higher than the previous quarter, reflecting its acquisition of gas producer Burlington Resources Inc. and increased volume from Libya.

The company said it was able to charge higher prices for crude oil in the period, but had lower prices for U.S. natural gas.

ConocoPhillips expects significantly higher worldwide refining margins in the quarter. It said its refining capacity utilization rate rose to the low 90-percent range as most of its domestic refineries returned to normal operations.

The Houston-based company also said it expects its midstream business to report similar results to the first quarter. It expects lower earnings from its chemicals and emerging businesses segments.

It also said it expects to record a second-quarter earnings benefit of around 25 cents per share from tax rate reductions recently enacted in Canada and Texas.