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Coming in at #9 in our Magic Formula Business Sector Rankings is the Energy sector. This sector accounted for 156 stock days tallied by 11 different stocks. Energy is a fairly diverse sector, covering several different industries. These break down as follows:

Morningstar Industry	Stock Days	Unique Stocks
Oil/Gas Products	69	3
Oil & Gas	51	4
Pipelines	20	1
Oil & Gas Services	16	3

Let's look at each of these industries and try to figure out why some of these companies are appearing on the Magic Formula screen. Are they inherently attractive businesses or are we looking at special situations?

Oil/Gas Products

The oil and gas products industry consists primarily of firms that take crude oil or other raw materials and convert them into usable products such as gasoline, motor oil, and diesel fuel. Refining as a business model is a tough one. First of all, refining is very capital intensive, requiring a lot of maintenance, upkeep, and replacement costs to keep refineries running smoothly. Secondly, there is no real way to build a competitive advantage with refining as a pure play business model. While OPEC protects crude oil prices for upstream (extraction) firms, nobody is protecting the cost of gasoline or motor oil! Lastly, refining profits are heavily cyclical, usually inversely dependent on the price of crude oil. Refineries buy crude and sell products, so an ideal situation for them is lower crude prices and relatively higher end product prices.

It's pretty clear that oil and gas products is not a particularly attractive business on an ongoing basis. For a period through 2006 and 2007, the environment was excellent for refiners. Gasoline prices spiked from around $1.80 per gallon to $3.00 a gallon (a 67% rise), while crude rose from about $50 to only about $65 (30% rise). Today, we have crude oil above $115 a barrel, while gasoline has gone up modestly, although still rising. Consumers and businesses are acutely aware of gasoline prices and at certain levels, they will cut back consumption. Refiners build good return on capital numbers during favorable times, but the situation looking forward may not be as promising. This sector looks to be a special situation that is risky to invest in.

Oil & Gas

Oil & Gas is Morningstar's catch all category for the integrated oil companies. There are a lot of steps in the process of extracting oil from the ground to selling it to consumers. First, the company must own or lease land that contains oil deposits. Then the company must extract the oil from the ground and get it to refineries via pipelines. These steps are called the "upstream" process. From there, the refineries convert the crude oil into products which are then marketed and sold to consumers. This is the "downstream" process. Companies in the oil & gas segment have operations to handle all of these steps. They are commonly known as "integrated" oil and gas companies.

This industry sector is more attractive than pure play refiners. OPEC maintains profitable crude prices, for the most part, making upstream operations more consistently profitable. Also, upstream is where competitive moats can be built, as the location and size of a company's reserves are major factors in profitability. Having downstream operations in addition is advantageous because the company may be able to extract it's own crude at significantly lower prices than market, giving their refineries a better chance of profitability. Still, this business is very capital intensive. Rigs, pipelines, ships, and tanker trucks must all be bought and maintained.

Almost all integrated energy companies maintain a high earnings yield, historically, so making the MFI screen is a result of high returns on capital. It's not hard to figure out the rest... historically high crude prices have delivered big profits to these firms over the last 3 years. Integrated oil and gas is not a bad industry, if you believe energy costs will continue to rise. On the other hand, if you feel we're in an energy bubble, as many do, these can be risky investments.

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Pipelines

Pipelines are what transport a large amount of the crude extracted from the ground to refineries. It's an attractive business with a built-in moat, because it is extremely difficult and expensive to acquire land and construct a new pipeline. Most pipelines are owned by the integrated oil and gas companies discussed above. These companies are unique in the energy industry in that they are not affected that much by crude oil prices. The rates they can charge are restricted by the government.

Since there was only one of these companies in the Magic Formula, a deep inspection is not really warranted. That one company, Energen (EGN), is not even really a pipeline but a propane distributor. Most true pipelines are limited partnerships of the major integrated players. It will likely be very rare that a true pipeline finds it's way into the Magic Formula screen.

Oil & Gas Services

Last, we come to the services companies. These firms provide services to oil extractors, such as supplying drilling equipment and providing geological information to determine potential drilling sites. Clearly, these companies are slaves to the cyclicity of the energy industry in general. When oil prices are high, extractors scramble to extract as much oil as possible to take advantage. This leads to high demand for new equipment and services. On the other hand, when the cycle is downward, there is little demand and historically services companies have absorbed large losses. Sustainable competitive advantages are rare - without significant switching costs or sticky businesses (these services are largely discretionary in nature), profits can disappear in no time.

Of the 4 industries discussed here, Services is the riskiest. The high returns on capital enjoyed by the 3 firms that made the MFI screen are clearly due to the oft-discussed high price of crude oil. Although this price may remain high, there are a growing number of energy analysts who believe that crude oil prices are in a "bubble". If it does deflate, we know from history these companies lose nearly all profitability. Even if crude oil stays high, the demand for services will not necessarily follow suit. With so many other more predictable and profitable industries out there, why take the chance?

Energy - Summary

As we've seen, with such large capital expenditure requirements, it's difficult for energy companies to maintain high return on capital without high crude prices. As such, it's no surprise that energy firms are pretty rare on the Magic Formula screen, and I would wager that more reasonable crude prices would bring the frequency down even more. I would recommend only large, integrated energy firms as Magic Formula picks. Exxonmobil (XOM) and Chevron (CVX) have been in the screen before, and these large integrated players have large reserves and their own downstream operations. Pure plays in this sector are more risky.

Magic Formula Business Sector Countdown

#9 - Energy

#8 - Software

#7 - Media

#6 - Consumer Services

#5 - Hardware

#4 - Industrial Materials

#3 - Consumer Goods

#2 - Healthcare

#1 - Business Services

MFI Business Sector Project

Disclosure: Steve owns CVX

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