Negative Trend for Oil E&P Stocks

Key Points:

• Falling oil and natural gas prices are causing brokerage analysts to reevaluate their forecasts on E&P companies
• During the past two weeks, earnings estimates have been cut on 41 E&P companies
• Positive revisions still outnumber negative revisions by a large margin, but the trend is clearly turning negative

Since early July, crude prices have dropped by more than 20%. Natural gas prices have dropped even more. Fears of weakening demand helped to deflate the energy bubble.

The demand concerns have been caused by revised forecasts for the energy sector and slower economic growth worldwide. Yesterday, the International Energy Agency proclaimed an easing to the tight global and supply balance that had played a significant factor in driving oil prices higher. Today, Japan said that GDP fell 0.6% last quarter.

Barring a supply disruption, such as a hurricane hitting the Gulf Coast, current trends suggest a further drop in oil prices.

For investors holding onto oil stocks, especially exploration and production (E&P) companies, this creates a problem. As I have previously stated on our Zacks Elite web site, brokerage analysts are likely using crude price targets of $110 to $120 per barrel in their profit forecasts.

Estimate Revisions

Starting last year, as the oil bubble inflated, brokerage analysts were forced to constantly adjust their models to reflect higher crude prices. This resulted in numerous positive revisions on oil exploration and production (E&P) companies. As long as oil remained above the prices used in the profit models, it was logical to believe that more positive revisions would occur.

Now the situation is reversing, with oil headed below what many analysts have factored into their models. Therefore, it is now logical to assume that profit forecasts will be lowered.

Profit Forecasts Starting to Get Cut

The numbers suggest a trend towards lowering profit projections has started. During the past two weeks, 81 full-year earnings estimates have been cut on E&P companies.

Andarko Petroleum (APC - Analyst Report) has received the most negative estimate revisions with 7 covering brokerage analysts cutting forecasts. Though APC exceeded second-quarter earnings expectations with profits of $1.76 per share, its revenues were a bit light.

Forest Oil (FST - Analyst Report) follows closely behind with 6 negative estimate revisions. Again, better-than-expected second-quarter earnings have not stopped brokerage analysts from lowering their full-year profit projections.

Denbury Resources (DNR - Analyst Report), EOG Resources (EOG - Analyst Report), Quicksilver (KWK - Analyst Report) and XTO Energy (XTO - Analyst Report) all have had five brokerage analysts cut their profit projections in the last two weeks. Earnings forecasts have also been cut on 35 other E&P companies.

Some Disagreement Does Exist, But The Trend Is Negative

As negative as this seems, the aggregate trend in estimate revisions for this industry group remains overwhelmingly bullish. The revisions ratio is 1.67, reflecting 214 positive revisions and 129 negative revisions. (Within recent weeks, 6 brokerage analysts have raised their full-year forecasts on APC and 3 have increased their profit projections on FST.)

The problem is with the trend, however. When oil prices peaked last month, the revisions ratio for E&P companies stood at 17.2, reflecting 241 positive revisions and 14 negative revisions.

Oil could fall to between $80 and $100 per barrel, barring any supply disruptions. Were this to happen, more earnings estimates could be trimmed on E&P companies.

This is not a case of anything being inherently wrong with the fundamental strength of these companies, but rather a change in the short-term risk/reward ratio. We have reduced our exposure to the energy sector in the Zacks Elite Focus List portfolio with the intent of adding back some oil and natural gas companies at lower prices.

For those wanting exposure to the oil and natural gas sectors, integrated oil and oil machinery and equipment stocks might be safer over the short-term. (We hold ConocoPhillips (COP - Analyst Report) and National Oilwell Varco (NOV - Analyst Report) in our Focus List and Top 10 portfolios, respectively.) Those unwilling to endure short-term volatility may want to consider waiting for oil and natural gas prices to settle, however.

Related ETFs

There are various funds with exposure to the energy sector. Two E&P pure plays are iShares Dow Jones U.S. Oil & Gas Exploration & Production (IEO) and First Trust ISE-Revere Natural Gas Index Fund (FCG).

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Zacks Premium and Zacks Elite subscribers can view the Zacks Industry Rank List at http://www.zacks.com/zrank/zrank_inds.php. This interactive list allows you to see all of the companies, and their Zacks Rank, within more than 200 industries. Shown below is the Zacks Sector Rank List, which shows the trend in estimate revisions on a broader scale.

Sector Rank as of Aug 13
Sector	This Week's Zacks Rank	Last Week's Zacks Rank	FY08 Revisions Ratio	FY08 Estimates Revised Up	FY08 Estimates Revised Down
Oils-Energy	2.53	2.41	1.41	729	516
Aerospace	2.68	2.90	3.31	139	42
Conglomerates	2.84	2.96	3.29	69	21
Medical	2.86	2.86	1.68	994	593
Industrial Products	2.90	2.89	1.31	272	207
Basic Materials	2.92	2.89	1.18	264	224
Utilities	2.98	3.00	1.12	203	181
Retail-Wholesale	3.00	3.04	0.90	390	435
Business Services	3.03	3.08	0.92	154	167
Computer and Technology	3.04	3.03	0.81	1125	1391
Transportation	3.05	3.13	1.61	273	170
Consumer Staples	3.06	3.00	0.90	221	246
Construction	3.13	3.14	0.81	113	139
Consumer Discretionary	3.16	3.16	0.65	277	424
Finance	3.30	3.31	0.52	903	1725
Auto-Tires-Trucks	3.35	3.32	0.46	58	125

Charles Rotblut, CFA, is the senior market analyst for Zacks.com. He can be reached at crotblut@zacks.com.