Skip to Content

Menu

Is Now the Time to Buy Oil Stocks?

March 20, 2017, 2:11 pm

Oil and gas was one of the best performing sectors in the previous decade. Everything went right for the industry in terms of oil prices, which traded briefly above $100 in 2008. There was incremental demand from China as that economy grew rapidly. New supply was limited as companies were cautious about exploration after the industry was burned with oil falling below $20 in 1998. In addition, increased speculation from trading desks also caused the price to spike at times. Today, we’re looking at a very different picture. Hydraulic fracking and horizontal drilling in North America has increased supply and greatly diminished OPEC’s pricing power. The Chinese economy has also cooled. New financial regulation has caused many trading desks to shut down.

As a result, oil prices fell sharply in late 2014 when OPEC could not reach agreements on production cuts. Today, the Energy Select Sector SPDR ETF (XLE) is up just 22% excluding dividends since the end of 2009, which stands in stark comparison to the S&P’s 111% rise. In addition to declining oil prices, many companies have been guilty of poor capital allocation decisions. For example, Exxon Mobil (XOM) overpaid for natural gas producer XTO Energy in June 2010, issuing $25 billion in stock and assuming $16 billion in debt right before natural gas prices plunged. XOM also borrowed money to buy its own stock at much higher prices than what it currently trades for.

Most investors think of XOM, Royal Dutch Shell and Chevron (CVX) as the big oil players. They’re certainly well-known, financially strong and diversified, but there’s much more to this industry than those three. There are also exploration and production (E&P) companies, which explore for, develop and sell unrefined product; refiners, which take crude oil and turn it into finished products like gasoline, heating oil and jet fuel; and integrated companies, which are a mix of two. E&P and refiner companies tend to be more volatile given their unpredictable earnings.

Some E&P names include EOG Resources (EOG), Occidental Petroleum (OXY), Anadarko Petroleum (APC) and Devon Energy (DVN). The profitability of these companies is set to improve this year as oil prices are still generally higher than they were a year ago. Still, like most stocks in this group, they carry PEs at 40 or higher based on this year’s earnings estimates, which is very high for companies that will not produce a lot of organic unit growth in the current market conditions. Therefore, I feel these stocks are already discounting oil prices well above current levels and are vulnerable to further downside if this price rise (which doesn’t look likely at this time) fails to materialize.

The refining companies are enjoying good profitability right now, as the lower price in oil combined with stable demand for finished products has provided decent profit margins (also known as crack spreads, which measure the difference on how much it costs to process crude to final product and how much the refiner can sell it for). However, crack spreads are subject to rapid change should inventories of finished product build or the price of crude surge. Occasionally, these companies can go through quarters with limited profitability or even losses. Due to this earnings volatility, along with extreme capital intensity and limited unit growth, refiners have generally sold for low PE ratios. Currently the major refiners, Valero Energy (VLO) and Tesoro (TSO) sell for PEs of 12X and 13X this year’s earnings estimates, respectively.

The integrated companies benefit from being in both businesses; while declining oil prices will hurt their E&P operations, it will help their refining operations. As a result, these stocks generally trade somewhere in between the valuations of refiners and the E&P names. Valuations will be higher than refiners, since earnings tend to be more stable, but lower than E&P companies, as earnings don’t have the same potential upside with higher oil prices. For example, XOM and CVX trade at 20X and 22X this year’s EPS estimates, respectively. As is the case with E&P stocks, at this level of valuation the shares seem to be discounting higher commodity prices going forward.

In addition to discounting an increase in energy prices that seems elusive, these companies need to spend more to replace reserves than they had previously, and unit growth will be limited by greater fuel efficiencies, alternative sources of energy and even mandated limits on demand if governments take more aggressive steps to limit consumption due to future climate change. I believe XLE will continue to underperform until its valuation is more reasonable or oil looks ready to move higher, and I feel the same way about oil service stocks like Schlumberger (SLB) and Halliburton (HAL).

Be the first to leave a comment.

* Required. Email address will not be shared.

By submitting a comment you grant Kramer Capital Research a perpetual license to reproduce your words and name/web site in attribution. Inappropriate and irrelevant comments will be removed at an admin’s discretion. Your email is used for verification purposes only, it will never be shared. Please note that comments will be not be responded to directly on this website, but may be addressed through future articles and other content.