Oil companies near multi-year highs. Still undervalued.

Oil companies should no longer be valued by their reserves. New drilling technologies like fracking and horizontal drilling mean oil companies operate more like advanced manufacturers, which have much higher price-earnings ratios.  

I can hardly believe that I'm about to write this sentence: oil companies - some of the most highly valued companies in the world - may actually be undervalued on the stock markets. Let me explain.

As those of us who follow the energy industry know, the oil industry is undergoing a sea-change. Usually cited as the result of a combination of hydrofracking and horizontal drilling, there is a boom in oil production. It is doubtless that those technologies were important, but it is how they have been paired with information technology and seismic imaging that has completed the puzzle. The companies now know where to drill and what will come out, long before any steel goes in the ground.

The results speak for themselves; only five years ago, North Dakota was producing 172,000 barrels of oil per day, today it is producing 779,000 barrels per day - an almost 5-fold increase. Similar things are happening at previously obscure shale plays around the country.

This is important to a company's valuation because in the past, oil companies were valued by the amount of reserves they have available. However, with this new suite of technologies, oil production has become more akin to advanced manufacturing. The companies apply skilled labor, scientific know-how, and large amounts of capital to a resource area that doesn't looks like a traditional oil field - and you get a valuable product out. Because of this, the oil majors should be treated more like manufacturing companies than resource extraction firms. Traditional oil drilling (as it is still practiced in most of the world) was like sticking a straw into a water balloon - you knew how much was in the balloon, and valued the company based off those estimates.

Today, we've essentially run out of water balloons: all the major fields of the world (save maybe some remote ones far offshore or in the Arctic) have been tapped and are in production. But, the lesson of the oil boom is that this doesn't mean we've run out of oil. It means companies can essentially manufacture oil out of inhospitable terrain.

Heavy manufacturing is undergoing a similar transition, as the application of advanced information technology is rapidly changing the industry by increasing productivity rapidly.

However, the markets haven't yet caught on to this difference. The major oil companies are trading at a Price to Earnings (P/E) ratio of about 8-12, with Royal Dutch Shell at 8.05, Exxon Mobil at 8.90, Chevron at 9.09, ConocoPhillips at 9.74, and BP at 11.95.

However, if we think that these companies are more akin to major manufacturers, then they are undervalued, and it could be by half! Major manufactures seem to have P/E ratios of 13-18, with Siemens at 16.40, United Technologies at 13.63, GE at 16.41, 3M at 16.49, and Honeywell at 18.78.

Therefore, so long as the world oil price stays high (as I argue it will in my most recent column on Energy Trends Insider) and there remains a market for their product, the major integrated oil companies should be valued much higher.