Still comfortable with oil stocks (page 1 of 3)

US Equities

After disappointing results from its fixed income division, Goldman Sachs Group Inc. (GS, $84.70, CSFB: Not rated) stock price lost 8.6% in four days last week, while competitors announced strong earnings from their fixed income businesses.

The company bought millions of dollars in mortgage portfolios from clients, but interest rates rose before it could resell them, leaving it with substantial losses (source: Wall Street Journal). We have a Buy rating on GS for trading investors, wanting to play a rebound in the stock price.

The U.S. Senate accepted a $368 billion defense-spending bill, sending it to President George W. Bush for his signature. Defense contractors Boeing Co. (BA, $34.01, CSFB: Outperform), Lockheed Martin Corp. (LMT, $45.43, CSFB: Outperform), and Northrop Grumman Corp. (NOC, $86.15, CSFB: Outperform) would benefit from the bill, which boosts the military's buying power for ballistic missiles, armoured vehicles, aircraft, and other equipment by $3.1 billion to $74.7 billion.

After a 7%-decline in stock price last week, due to several downgrades in aerospace & defense sector, we re-iterate our Buy rating on Northrop Grumman, believing current stock price offers an attractive buying opportunity for the long-term.

OPEC decided to cut its daily production by 900,000 barrels to 24.5 million starting November 1. The organisation had already raised concerns earlier, that the current production would exceed global demand. Crude oil prices declined sharply in late August, after US inventory levels saw an unexpected increase. The end of the US summer holiday driving season would have suggested a large draw in inventories, keeping demand levels high.

Another factor weighing on crude oil prices was an increase in Iraqi production. Latest estimates see Iraqi production at 1.28 million barrels a day, about half the level of output the country had before the war.

OPEC also signalled that it would decide to cut quotas further if necessary, during its next meeting in December. This was interpreted as a hint, that crude oil prices could continue to come under pressure and led to profit taking in oil industry stocks.

We expect the sector to remain volatile over the next days, but medium term the inventories for heating oil being still 10% below year ago levels and with the start of the winter season starting in six weeks, demand from this side should keep crude oil prices stable at high levels. Hence we remain comfortable with the outlook for the oil sector.

An investigative hearing in the US House Energy and Commerce Committee took place last week, in order to shed light on drug companies pricing practices in Medicaid. Medicaid is the government health insurance of the poor and represents about 16-18% of total pharmaceutical spending. The hearing was part of an ongoing investigation by Congress on this subject, hence not a new issue. The question the committee was addressing was whether drug companies have been manipulating the Medicaid payment structure, or whether the states are getting the rebates they are entitled to.

Beside this we are also looking for an acceleration of the work on the Medicare reform bill. October 17 could be a tentative deadline for a comprehensive proposal. Although the Congress is not expected to trim down the benefits, there are some issues that could have a negative impact on the pricing power of the pharmaceutical industry, such as drug re-importation and the Waxman/Hatch provisions that would make it easier for generics to come to market.

Looking at the valuations in the pharmaceutical stocks, a widely negative outcome of the Medicaid hearings and Medicare drug bill appear to be priced in.