How to Bet on Oil_Whether Bull or Bear

The surge in oil prices has been so rapid and relentless--up 28% just in the past five months and 94% over the past year--that investors may think it's too late to grab a piece of the action.

Of course, they may have thought that when oil was at $80 a barrel, or $100, or $125. But now many forecasters think oil could go beyond the low $130s it reached in late May--maybe toward $200 a barrel over the next year.

At the same time as oil bulls paint a picture of dwindling supply coupled with record demand from India and China, dissenters maintain that prices are driven increasingly by speculation, not by a long-term shift in fundamentals (BW--June 9). With views about oil prices for the next six to 12 months all over the map, here's a guide to investing in oil whether you buy into the bullish case, are agnostic on the future price of oil, or are a downright bear.

IF YOU'RE AN OIL BULL...

Few investors are as bullish as Matthew Simmons, president of Houston investment bank Simmons & Co. International, who predicts oil will hit $200 to $500 a barrel over the next six months to five years. But a growing number of investors think $150 to $200 is within range over the next year. Those investors should consider some of the Canadian oil sands stocks, says Tim Guinness, chief investment office for Guinness Asset Management in London. Unlike major integrated oil companies, these producers aren't struggling to expand production, with reserves, which are owned by the Province of Alberta, seen lasting 40 years.

Guinness' favorite is Suncor Energy (SU), based in Calgary, Alta. Its production is expected to increase by two-thirds over the next 8 to 10 years, and earnings should rise 10% a year. "Its revenue stream will rise proportionately to the oil price," says Guinness. The reserves are near the surface, and it's easy to establish where and how thick deposits are, he says. Since Suncor negotiated an increase in the royalty rate it pays Alberta this year, he expects the rate to be stable for a few years. At 68.56, Suncor trades at 18.7 times 2008 earnings, and is up a split-adjusted 54% from a year ago. If oil prices top $150, Suncor could reach 80, says Guinness.

Integrated oil companies--the outfits that do it all, from exploration to refining--also need rising oil prices to offset cost inflation, or profit margins start to contract, says Tim Parker, an energy analyst at T. Rowe Price (TROW). An attractive integrated producer is Murphy Oil (MUR), he says. Its production is expected to grow 35% this year as its offshore, deepwater Kikeh oil field in Malaysia ramps up. Kikeh is scheduled to reach full production of 120,000 barrels a day by yearend.

Murphy also has 25 exploration wells in Malaysia and the Gulf of Mexico that start up in June. "They're not all going to work, but it's a nice portfolio of exploration coming up," says John Segner, senior portfolio manager of the $2.5billion Aim Energy Fund (FSTEX). "It's fairly valued, and you're able to get all this exploration work started for free because the stock isn't reflecting the potential for new [reserves]," he says. At 94.88, Murphy trades about 12 times projected 2008 earnings. Shares are 2.2% below the 52-week high, hit on May 20, of just above 97.

Daniel Rice, who co-manages the $1.47 billion BlackRock Global Resources Fund (SSGRX), prefers exploration and production companies, since profits at integrated producers are constrained by refining and marketing businesses. The stocks could move another 20% as long as oil prices continue to rise, he figures. One of his top picks in the sector is Plains Exploration & Production (PXP) (GO-A.TO), mainly because its production mix is 50% oil and 50% gas.

Energy Stocks with Room to Run

A New Way to Make Music in India

Tucked away inside an old textile mill compound in Mumbai's Lower Parel area, with no sign to announce its presence, is the Blue Frog, the city's popular live music nightclub and jazz joint. Life begins at 10.30 p.m. here, with the place packed with music-lovers from around the city and around India, and visiting foreigners in the know. The Blue Frog has been around for a year, and on May 19 made a giant leap from nightclub to professional music production house—India's first. The studios are located right behind the club, in a 10,000-sq.-ft. former mill, complete with skylights, high-tech equipment, and vibrant contemporary Asian art.

Based on the initial reaction from India's advertising and entertainment industry, Blue Frog's bold move seems to be a winning one. On opening night every important player from the music, film, and advertising worlds showed up to witness this new venture: singers Lucky Ali, Ila Arun, and Rags Khote were there, along with advertising filmmakers Prasoon Pandey of Corcoise and Ayesha Sayani of Shunyata Productions, and Sony-BMG chief Shridhar Subramaniam, WPP group's India country-head Ranjan Kapoor, veteran singer Gary Lawyer, hot young VJs, and musician-turned-politician Milind Deora.

Young, hopeful musicians were also there, including the Blue Frog record label's first recording artists, the duo Shaair 'n' Func. "This is the Taj Mahal of the music world," says Luke Kenny, a former Channel V veejay-turned-Bollywood actor. "It's especially great for aspiring musicians."

One-Stop Shop for Music

The conceptual guru of the Blue Frog is Ashutosh Pathak, a successful composer of ad jingles, operas, and rock music, who had been dreaming of a full-service, professionally run music studio for two years. Previously, India had none. Those great Indipop songs? All produced out of individually owned shops, mostly run by Bollywood directors or producers, who rent out the facilities. Even sophisticated ad jingles are dependent on a fragmented system, where recording and production happen in different places. Worse, there are no standardized rates—fees are ad hoc, making it hard to budget for films, for example, says Pathak. "This business was like the Wild West," he says.

Blue Frog, the studio, intends to change all this. It will be a one-stop shop for anyone who wants music of any kind, be it Bollywood, ad films, computer games, or rock. The studio is open 24 hours and every day. There are set rates for professionals at all levels, eliminating the usual bargaining, overpricing, and exploitation particularly of young artists. And best of all, the nightclub serves as a place to debut.

The venture is already starting to pay rewards. On June 2, for instance, Columbia Records announced its intention to enter the Indian market at the Blue Frog with a performance by Virgil Donati, an Australian drummer with a large following in the drumming world.

Fortuitous Partnerships

The boyish-looking Pathak, 36, is among the most popular composers for commercial advertising jingles in Mumbai. He also writes lyrics, sings, and plays guitar and keyboard as part of a duo band, Smoke, with partner Dhruv Ghanekar. Smoke cut its first record with Blue Frog last month. He has also shown himself to be a typical entrepreneur who persists, persuades, and never gives up. When he came up with the idea of a nightclub and more for India two years ago, he knew he couldn't do it alone. So he flew to Singapore to meet banker-buddy Simrin Mulchandani, who had moved from an investment banking job at JP Morgan (JPM) in New York to run his own hedge fund in Asia.

The timing was right. Mulchandani was ready for a change and happy to talk music with Pathak. By September, 2007, Mulchandani had wound up his fund and moved to Mumbai to be the new venture's chief executive. Apart from the complexity of building a world-class, professional studio in India—Blue Frog has the usual floating floors and Foley pits—getting the talent with the appropriate skills for such a groundbreaking venture was a task. "The execution was tough," says Mulchandani. It helped that two other partners, high-flying ad film and documentary maker Mahesh Mathai and his producer wife, Srila Chatterjee, were plugged deep into the music and advertising world.

Now that Blue Frog is up and running, the founding team wants to do it all over again. Plans are afoot to launch Blue Frogs in New Delhi, Singapore, and Dubai, the new music-tour circuit for the kind of music India is now producing—a music that reflects "contemporary India," says Pathak. "Our influences are from around the world, and we are not afraid to express ourselves." The grand plan, he adds, is to funnel international talent into India and expose local talent to listeners abroad. "Our company is the musicians' gateway to India, and Indian musicians' gateway to the world. If you come to India from anywhere in the world, for any kind of music, you can come to Blue Frog," Pathak says.

Exit Bharti, Enter Reliance in MTN Tango

Pricey Oil’s Ugly Spillover

India: Soaked by Oil Subsidies

Russia's Raiders

It seemed like any other workday at Togliatti Azot, a giant chemical factory in Russia's Samara region, on the Volga River 600 miles east of Moscow. Engineers were on their morning rounds, and union representatives had just finished a talk about financial support for newlyweds. Then around 11 a.m., dozens of men dressed in camouflage and toting automatic weapons charged into the administration building. "We thought it was a terrorist attack," Sergei Korushev, the plant's deputy director, says of the September, 2005, raid.

In fact, the uninvited visitors were members of the local OMON, Russia's crack paramilitary police, and detectives from Moscow. They seized thousands of financial documents—evidence, they said, of crimes by management. The police later brought charges of tax evasion and fraud against General Director Vladimir Makhlai and CEO Alexander Makarov, both of whom have since left the country. (Neither could be reached for comment.) While the company has been hit with $150 million in back tax claims, many at Togliatti Azot have their own explanation for the events. "Someone wanted to eat up a very good and very lucrative morsel for their selfish goals," says Korushev. The plant's current boss, Yuri Budanov, calls the police probes a "shakedown," which a local politician links to a rival company.

Budanov and Korushev, like many Russians, believe the police and courts have become weapons in the capitalist arsenal. Some 8,000 companies a year are targets of lawsuits or investigations at the behest of rivals seeking to put them out of business or take them over, the Russian Chamber of Commerce & Industry says. Russians call this process reiderstvo, or raiding. In some of these cases, companies pay off police and courts with a goal of harassing competitors. Often raiders rely on corrupt courts to rule that they are legal owners of a company. In other cases, raiding companies or their agents use legal pressure as a tool to force controlling shareholders to sell their stakes. While targeted companies sometimes don't know who is behind the legal attacks, the practice is common enough for the Russian press to name the prices corrupt officials allegedly charge for various "services": Getting police to open a criminal investigation costs $20,000 to $50,000, an office raid is as much as $30,000, and a favorable court ruling runs anywhere from $10,000 to $200,000, according to press reports.

Rampant lawlessness is the No. 1 barrier to Russia's economic development, says President Dmitry Medvedev. The former law professor, who promised to make law and order a top priority, has coined his first catchphrase, "legal nihilism," to describe widespread disrespect for the law at all levels of society. Medvedev, who took over the Presidency from Vladimir Putin on May 7, has called for legislation to rein in reiderstvo, and Parliament is debating a 20-year jail sentence for raiders who illegally acquire companies.

VENALITY ON THE VOLGA

Sometimes Russia's legal shenanigans make global headlines. Oil giant Yukos was broken up and renationalized by the Russian government between 2003 and 2007. Police on Mar. 20 raided the Moscow offices of BP (BP) and its Russian joint venture, TNK-BP. And on Apr. 6, Hermitage Capital Management, a British investment fund, said Russian police, under cover of an investigation for alleged tax evasion, stole documents that were then used in an attempt to defraud the fund. (The police did not comment.)

While such cases capture worldwide attention, reiderstvo more typically targets small and midsize companies in places like Samara. Located on the historic trade route with Asia, Samara has long had a wild streak. In the 17th century, the city—the capital of Samara province—was the base for Russia's most notorious outlaw, a Cossack named Stepan Razin who held up riverboats. In the 1990s criminality in the region centered on the giant AvtoVAZ car factory in Togliatti, Samara's second city, where mobsters stole cars and gunned down managers.

Why HP’s Deal Is a Head-Scratcher

India: Soaked by Oil Subsidies

You'd think Sarthak Behuria, chairman of Indian Oil, would be one of the world's happiest executives. His state-controlled company, with $59 billion in revenues, is India's largest refiner of oil into such products as gasoline and diesel, which are eagerly bought by increasingly affluent consumers and expansion-minded companies. Its 17,800 gas stations are ubiquitous on Indian roads.

Yet Behuria, far from raking in the profits, is struggling to save his company from imminent bankruptcy. Indian Oil is running losses of $76 million a day, and will run through its line of credit of $21.4 billion by July. That's because the government has insisted that Indian Oil subsidize all the gasoline, diesel, and cooking oil it sells, so much so that prices are a third cheaper at the pump in India than they are in the U.S. Since the oil it purchases abroad is so much more expensive than what it sells at home, Indian Oil basically loses money every time it makes a sale. So do the two other state-controlled oil companies, Bharat Petroleum and Hindustan Petroleum.

To defuse the crisis, the government of Prime Minister Manmohan Singh raised fuel prices an average of 13% on June 4. That will not be enough to rescue Indian Oil, but it has already kicked off a political storm. The country's Communists and opposition groups are calling for nationwide strikes to protest the price hikes.

Political Backbone?

India's dilemma reflects one of the big distortions in the energy industry today: the widespread use of state subsidies to soften the blow for consumers in Venezuela, China, Taiwan, India, and beyond. The soaring costs of these subsidies are hammering government budgets in many emerging markets. Indonesia was so squeezed that it just reduced its subsidies drastically. Malaysia is doing the same.

In India, the political courage to terminate the subsidies is lacking. The country faces a slew of elections coming up this year—five in important states before December—as well as national elections in 2009. Remove subsidies? Unlikely. "It's a huge dilemma from the political management perspective," explains Subir Gokarn, Standard & Poor's chief economist for Asia-Pacific. (BusinessWeek and S&P are both part of The McGraw-Hill Companies (MHP).)

Meanwhile, the Indian market has suffered tremendously from the unexpected consequences of subsidies. Private players like Essar Oil and Reliance Petroleum had begun a major rollout of gas stations. But as oil prices began to soar, their higher, unsubsidized prices proved uncompetitive with the subsidized prices of such state-owned players as Indian Oil and Bharat. Unable to compete, Reliance Petroleum has shut down all 1,400 of its new gas stations, while Essar Oil has shuttered half its 1,250 pumps. Multinational Royal Dutch Shell (RDSA) has closed 40 out of 50 stations.

A Circular Road

Many executives at Indian corporations believe the subsidies are bad policy. "Removing subsidies will have a serious impact on the economy, but so will a large public deficit," says Venu Srinivasan, chairman of TVS Motor, a popular motorcycle maker. Yet even a small hike in fuel prices—particularly in the diesel oil widely used by commercial trucks—will push inflation higher. That would cut consumer spending and, of course, stoke voter wrath.

Delhi may keep cutting subsidies cent-by-cent over the next year to mitigate the political fallout. But those cuts might prove too little for India's oil companies, and way too much for Indians accustomed to cheap fuel.

Pricey Oil’s Ugly Spillover

Why HP’s Deal Is a Head-Scratcher

Exit Bharti, Enter Reliance in MTN Tango

Wal-Mart, Your Friendly Drugstore

Wal-Mart Stores (WMT) wants to be your low-cost destination for not just food, clothing, and housewares, but also drugs and health care. In the past few months, Wal-Mart has announced it is working with several companies to process and pay their prescription claims. The company is aiming to increase electronic prescriptions at its stores by 400%, to 8 million by yearend. It is introducing walk-in clinics at its superstores to treat minor ailments and is expanding its $4 generic-drugs program. "What our company does best is exactly what the U.S. health-care system needs the most. It needs more affordability. It needs more accessibility. It needs to be more efficient," said H. Lee Scott, chief executive officer of Wal-Mart, in a speech earlier this year.

Sound familiar? It's an echo of Wal-Mart's initial steps into the food business 20 years ago. Today, groceries are Wal-Mart's biggest revenue generator, making up 41% of its annual sales. Along the way, Wal-Mart has dramatically reshaped the grocery store industry. Now it's making a bid to do the same in health care.

The low-cost strategy is paying huge dividends for the world's largest retailer as it heads into its annual shareholders' meeting on June 6. At a time when Americans are being weighed down by record-high prices (BusinessWeek.com, 4/14/08) on everything from gasoline to milk, flour, and eggs, Wal-Mart's new slogan, "Save Money, Live Better," is resonating more strongly than ever for millions of consumers who have consolidated their shopping into one weekly trip to one of the chain's massive stores. On Thursday, the company reported sales at stores open a year or more rose a higher-than-expected 3.9% in April, one of the strongest performances recorded by an American retailer. That's why Wal-Mart shares are trading near a six-year high, at 59. "It's a strategy to get people to come in for different aspects of their life, but all at lower costs," says David Abella, a Wal-Mart shareholder and portfolio manager at New York's Rochdale Investments, which has $2.3 billion in assets.

Hefty Profit Generator

Already, Wal-Mart's drug and health-care ventures provide big chunks of its sales and profits. The chain says that health and wellness products (including pharmacy sales) made up 9% of its overall $374.5 billion in revenues in the 12 months ended Jan. 31, 2008. Analysts say the profitability of the health-care lines was better than Wal-Mart's overall 23.5% gross margin last year.

The investment in health care could pay even bigger dividends in coming decades. Health-care costs are expected to continue spiraling upward in the U.S., especially for the estimated 80 million baby boomers, who were born between 1946 and 1964. According to the Census Bureau, 300 people in America turn 60 every hour, and health-care spending averages $3,262 for those aged 55 to 64. That expense typically climbs 20% per year for those over 65.

"People are worried because health-care costs are growing faster than the average American's income, and it's only going to get more intense as boomers retire at an increasing pace," says Len Nichols, health-care economist at The New America Foundation, a nonprofit public policy institute in Washington. Says Abella: "It is important to cement your health-care credentials as the leader of low-cost drugs at a time when baby boomers are getting older by the millions."

Unbeatable Prices

For two years now, Wal-Mart has been trying to do just that. It has shaken up the industry in the process. After it started offering a group of generic prescription drugs for $4 in September 2006, Target (TGT) and Costco Wholesale (COST) followed suit. Costco started offering $4 for a 30-day drug supply and then changed to $10 for a 100-day supply; now Wal-Mart has a similar offering.

Even at $4, generic drugs are not a loss leader at Wal-Mart. In its annual report, the company says that its gross margin increased in fiscal 2008 because of higher sales in fresh food and pharmacy. Rochdale's Abella says: "Wal-Mart might not be making the profits on $4 generics that drugstores were making, but generics have always had higher margins than branded drugs, and Wal-Mart is certainly not giving them away."

On May 5, Wal-Mart expanded its low-cost offering to cover women's medications to treat breast cancer, menopause, and hormone deficiency. For instance, alendronate, a generic version of the osteoporosis drug Fosamax, is being sold for $9 for a 30-day supply or $24 for a 90-day supply. That compares with $54 for a 30-day supply of the generic or $102 for the branded drug at pharmacy stores. The move should "help gain critical share across its female primary shoppers, and also drive traffic cross-shopping," wrote Adrianne Shapira, a retail analyst at Goldman Sachs (GS) who follows Wal-Mart, in a recent report.

Cancer’s Cruel Economics

Builders: Give Home Buyers a Tax Credit

Robert Toll took time out from explaining his company's dismal earnings report on June 3 to pitch a proposal. To shore up the real estate market, and the economy in general, he said, Congress should pass a bill to give tax credits to home buyers.

Toll and other builders suffering through the downturn think that homeowners need extra incentives to get off the sidelines. Their pitch goes like this: If the government simply bails out people whose home values have dropped below their mortgage amount, or spends hundreds of billions of dollars on Federal Housing Administration loans, prices will continue to drop, and those government-subsidized loans also will end up under water. Better to urge potential home buyers off the sidelines and back into the market, so prices can stabilize.

"I believe that this is the way to stabilize the economy," Toll, chairman and CEO of Toll Brothers (TOL), said in an interview on June 4. "Before trying to straighten out the credit market, you need to straighten out the basis of the problems in the credit market. You want to look at the asset that backs up that credit."

Reinflate the Bubble?

However, that "fix" alarms some economists and other financial experts, who think that a home-buyer subsidy will only serve to reinflate the housing bubble.

Toll said it has been done before. Congress passed a tax break for home buyers during a real estate downturn in the mid-1970s, he said, giving them a $2,000 credit for entering the market. About six months ago, Toll started to talk to lawmakers about a similar plan, although he thinks the pot needs to be sweetened to $15,000. He said he pitched the idea to Treasury Secretary Henry Paulson around that time. In February, Senator Johnny Isakson (R-Ga.) introduced a bill that echoed Toll's proposal.

The National Association of Home Builders has been pushing a tax-credit proposal since November, said Jerry Howard, chief executive of the NAHB.

Both the House and Senate versions of the Foreclosure Prevention Act include some form of tax credit for home buyers. The House bill offers buyers who have not owned a home in at least three years up to $7,500 in refundable credits if they buy a home in the next year. Single buyers with adjusted gross incomes less than $70,000 and couples making less than $140,000 are eligible for the full credit. The Senate bill gives buyers up to $7,000 if they purchase a foreclosed home.

Further Tax Benefits

The Senate also included other tax benefits for homebuilders, allowing them to charge current losses against the large gains they posted during the boom. House and Senate negotiators have begun meeting to resolve the differences between the bills.

Toll said targeting the tax credit only to certain buyers—such as first-time buyers or those buying foreclosed homes—is "silly" because it won't effectively spur the entire market. "The move-up guy can't move up," he said.

There is no doubt homebuilders are in trouble. Toll Brothers, which builds luxury homes, reported a loss for its fiscal second quarter of $93.7 million, after $288.1 million in pretax writedowns. Hovnanian Enterprises (HOV) reported a $340.7 million loss for the same period. Lennar (LEN), the largest U.S. homebuilder, is expected to release its latest quarter's results at the end of the month.

The earnings releases arrived on the heels of a National Association of Realtors report that showed inventories of unsold homes climbed 10.5% in April over March. The increase—to more than 4.5 million homes, or 11.2 months' worth of supply—came after inventories had held relatively steady for about four months. Sales of existing homes in April were down 17.5% from last year. "With inventories so high, it will be difficult for the market to bottom," said Eric Landry, an associate director at Morningstar Research (MORN) who covers the building market.

Making Sure Your Art Is Yours

Home Depot and Lowe’s Get Hammered

Facing an Auto Slump, Japan Lifts Capacity

In the midst of a dramatic earnings slump, Toyota (TM), Nissan (NSANY), and Honda (HMC) are ramping up production fast. Not in the U.S., their most profitable market, but back in Japan, where domestic auto sales just hit a 25-year low.

Every major Japanese automaker is building plants at home or adding capacity to existing ones. A Toyota subsidiary is constructing a 120,000-car plant in Miyagi, north of Tokyo. It's Toyota's first such plant in Japan since 1993. Nissan, which not so long ago was slashing production in the country, is expanding capacity by 22% at its Kyushu factory. Honda is spending $1.5 billion on a new factory and engine plant in Saitama, just outside Tokyo. "The time has come for our Japan operations to once again take the initiative," Honda President Takeo Fukui told reporters on May 21.

Why all the outlays? After all, Japan's carmakers have long had a policy of opening plants in overseas markets to avoid import duties and to hedge against currency gyrations. Japan remains an expensive place to make cars, with wages 10 times higher than in China. A shrinking population is causing labor shortages. The yen's recent 15% surge against the dollar makes Japan-made cars even pricier. Throw in contracting domestic sales, and the moves seem to defy business logic.

STILL A GOOD DEAL

One explanation is the flexibility that the investment brings. Japan's high-tech plants excel at switching production from one model to another. That's especially useful when auto demand is sinking or flat in mature markets but surging in the Middle East, Russia, China, and India. Nissan's Kyushu plant, for example, exports to 160 markets and produces eight different models on a single production line.

Anxiety over quality is another factor in the increase of production back home. In recent years, Toyota has had to issue numerous recalls, while Nissan's Canton (Miss.) plant became notorious for its defects during a production speedup. Executives are loath to admit that one plant is better than another, but Japanese makers' domestic factories score higher on quality than equivalent plants overseas.

Japanese engineers and workers, while more expensive than their counterparts in developing markets, are still a good deal. One reason is that Japan's wage levels, after barely rising in a decade, are not as high as they once were relative to other developed countries. According to consultant AlixPartners, Japanese industrial workers in 2006 made around $22 an hour, just two-thirds the level in Germany. Moreover, it's still rare in Japan for workers to switch from one automaker to another, so a well-trained, seasoned workforce is a given. "It's not so expensive in Japan, and when you consider the quality, motivation, and diligence with which people work, the value-for-money is unbeatable," says Markus Schdlich, president of Karmann Japan. In December, Karmann, a German company that makes convertibles under contract for Audi, Mercedes (DAI), and Nissan, will begin production at a factory in Japan.

The notion of mother plants, which test new technologies that later filter out to plants worldwide, remains strong. Fukui predicts Honda's Saitama plant will set an example for its plants globally. Labor productivity is expected to be 20% higher than in existing plants, thanks to greater automation and advances in welding and painting. Honda aims to cut the amount of energy used to produce each car by more than 30%. Honda and its Japanese rivals are not abandoning their plan to make cars around the world. But they are strengthening Japan's role as the essential benchmark.

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