The other day, I was asked how to play high oil prices in this market. One person suggested the obvious way to play things was with oil services, but I’ve heard those stocks touted so much and so long that I feel compelled to look upstream to the E&P majors as an alternative.

The example I used was ConocoPhillips (COP), which has long been noted to trade at a discount to Exxon (XOM) and Chevron (CVX). I worked through the implied market price of the reserves held on Conoco’s balance sheet; it came out to about $15/barrel. With $22/barrel in production costs - though only half of that is cash, the rest relates to DD&A - it makes much more sense for Conoco to buy back stock instead of exploring for new reserves, which cost just over $30/barrel to find and bring online in 2007.

I ended by noting that an E&P ETF (PXE) had been gaining momentum relative to the Oil Services HOLDR (OIH), and suggested buying PXE against a short on OIH.

Doing similar calculations for Chevron, one arrives at a market value of $18.90/barrel - keeping in mind, that value is only derived from enterprise value divided by reserves, and does not include other assets the company has such as refineries. Still, it looks like Chevron has lower production costs per barrel than Conoco, although I have a feeling things aren’t exactly comparable due to tax differences.

Moving to Exxon, the market is valuing their proven reserves (all figures in oil equivalents) at $20/barrel. This is in-line with what I’d anticipate, because Exxon has a lower cost per barrel of production at $7.14 against Chevron at $8.58 = don’t things look so orderly under these scenarios? Still, Conoco’s average cost of production stripping out non-income taxes is in the low-to-mid $7s per BOE, leading to my thinking that the stock is inexpensive relative to other major oils.

I wrapped up my thoughts thusly:

So why do I prefer the E&P majors over the oil services companies? Valuation is a part of it, but given that substantially more shareholder value is created through share buybacks as opposed to reinvestment (i.e., where the services companies make their money), E&P isn’t going to be the first capital spending priority of the oil majors, especially considering that E&P costs per barrel continue rising, while the stagnant market values of the oil majors have resulted in value compression in favor of buybacks.

…and then suggested a long PXE position against a short OIH position. But forget OIH for a moment, and concentrate on the market pricing of PXE relative to oil prices since the start of 2007:

That chart hits at the heart of what I’m saying; relative to crude prices, the oil majors are down over 30%. While I think part of this is due to a realization of value problem because it will take a lot of money flow to budge the valuations on Exxon, et al., and those dollars seem allocated directly to commodities for the time being, there is only so long the price-value discrepancy can exist, especially when the companies themselves are out buying back tens of billions in stock annually with their massive cash flows. While it might take some suspension of disbelief to envision XOM at $130 for a market cap of $700 billion, at these crude price levels it isn’t that far of a possibility. Of course, if XOM does get there, their stock wouldn’t look so cheap and suddenly the value creation equation might shift in favor of the oil services, but that’s a ways off and we should have plenty of time to reassess if and when that comes to fruition.

One last note: for those of you interested in an even longer perspective, we’re currently sitting at an all-time record low for PXE relative to oil:

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