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Economic Moats in Energy
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It's not easy to create a lasting economic moat in an industry that's so strongly affected by commodity prices, but a few energy firms have managed to do so. Here's how.

The energy sector is prone to intense cyclically. Small changes in available supply and market demand tond to have an oversized effect on commodity prices and profits. However, neither cyclical peaks nor valleys tend to last very long. It is important to realize this before investing in the sector. Otherwise, you might be tempted to sell when the sector is doing relatively poorly (when things are about to begin looking up again) or buy at the peak when the companies are reaping a windfall (when growth is about to go into reverse). For example, ExxonMobil might have looked expensive in 1999 when it traded at more than 30 times trailing earnings that were depressed by the cyclical lows. However, earnings rebounded sharply, and the stock has outperformed the market since then. In general, crude above $30 a barrel represents a cycli­cal peak, near $10, a trough.

By far, the most significant factor today that helps the companies that produce oil is the OPEC cartel. Though the cartel controls only a bit over a third of the world's oil output, the energy markets tend to be highly sensitive to small disruptions and spikes in supply. This gives OPEC more than enough power to manipulate commodity prices for the entire industry's benefit, keeping long-term commodity prices above the long-term costs to produce the commodities.

In addition, with reserves in OPEC's member countries far outstripping current production, it looks as though the cartel's influence will not be diminished soon, even with its member countries tending to slightly cheat on their quotas. If anything, OPEC's influence "will strengthen over time as non-OPEC reserves continue to be depleted at a faster rate than OPEC reserves.

OPEC's goal, at this writing, is to keep oil prices in the $20 to $28 a barrel range. Below this range, profitability starts to suffer. Above $30, volumes suffer as consumers start to conserve and global economies start to sputter. To understand just how beneficial it is for energy investors to have OPEC influencing commodity prices, take the cartel's $20 to $28 target range and consider that most oil companies are profitable as long as oil prices stay above the mid-teens. The bottom line is that OPEC is highly beneficial to the industry's profitability and is one of the primary reasons the oil companies have been very solid investments.

Though OPEC has been successful at boosting commodity prices, its power over the market is not absolute. After all, OPEC's members can each cut only so much, and cuts don't always make an immediate impact. More­over, when oil companies operate in OPEC-member nations, they are occasionally required to limit what they pump to maintain quotas. Still, this is a small inconvenience relative to the benefits the industry receives from the cartel's existence.

Economies of Scale

As in any other commodity industry, economies of scale play a major role in the profitability of energy companies. While costs upstream (finding and drilling oil) are largely a function of geology and geography of a company's reserves, keeping costs down can still provide a competitive advantage here. Downstream (refining and marketing), however, economies of scale are critically important because it is just about the only meaningful economic moat a company can build.

The fact that economies of scale play a major role in the Industry can plainly be seen in the financial statements of the oil companies. Profitability and returns on invested capital are highly correlated to a firm's size. Larger companies have greater sway with suppliers, can spread overhead costs over a bigger base, and can generally ride out cyclical lows better.

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