Wall Street is giving up on the energy business. Investors may want to consider getting in.
The backdrop for the hard-hit group has worsened in the past month. Fourth-quarter profits were weak, headlined by a nearly 70% drop in operating earnings at Exxon Mobil (XOM), excluding asset sales. All major areas are hurting—energy production, refining, and chemicals.
The current quarter looks even worse. Oil prices, as measured by U.S. benchmark West Texas Intermediate, have slid 16% in 2020, to $51 a barrel, amid concerns about the impact of the coronavirus on Chinese demand and global economic activity. U.S. natural-gas prices are at rock-bottom levels in what is normally the strong winter heating season, at below $2 per million BTUs, down 26% in the past year.
There is, however, a disconnect between the U.S. stock market—which hit records this past week as investors look beyond the coronavirus—and the lagging energy sector. For one thing, the group offers some of the best dividend plays. The largest Western energy companies—Exxon, Chevron (CVX), BP (BP), and Royal Dutch Shell (RDS/B)—yield 4.7% to 7.2%. The payouts look secure, with Royal Dutch carrying the majors’ highest yield.
“The big energy stocks are one of the most attractive areas that we see in the market,” says David King, manager of the Columbia Flexible Capital Income fund (CFIAX). Investors can get a reasonable return simply from the dividends and don’t need to see much appreciation in their depressed shares.
There are signs of capitulation from investors. The weighting of energy stocks in the S&P 500 index (.SPX) is down to a record low 3.8%, and the entire sector’s value is considerably less than Apple’s (AAPL) $1.4 trillion.
The group has trailed the S&P 500 for seven of the past eight years and is on pace for another year of underperformance; it’s down 10% in 2020, against a 3% rise in the S&P.
Investors can get exposure through the Energy Select Sector SPDR exchange-traded fund (XLE), which owns the energy stocks in the S&P 500 index. It trades at $54, after hitting a 52-week low this past week, and yields 4.3%. About 40% of its assets are in Exxon and Chevron.
A more speculative play is the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which trades at $19 and yields 2% after touching a record low this past week. Its largest holdings include Apache (APA), Occidental Petroleum (OXY), and EOG Resources (EOG).
A case can be made for most of the integrated majors, as well as ConocoPhillips (COP), the largest U.S. energy and production company. King is partial to Chevron and BP. Chevron, which trades around $110, has the industry’s best balance sheet, strong free cash flow, and a 4.7% yield after a recent dividend increase.
BP, which has successfully restructured its operations since its Gulf of Mexico oil spill a decade ago, yields 6.7%. BP, whose U.S.-listed shares fetch about $37, raised its dividend slightly this past week.
BP and Royal Dutch have lower price/earnings ratios than their U.S. peers, reflecting in part the increasing aversion to energy stocks in Europe, where investors are seeking to make a statement on climate change. ConocoPhillips, whose shares trade around $58, offers a good mix of dividends and stock repurchases. It yields 2.9%.
Exxon, at $62, is the least attractive, even after a recent drop in its shares to a 10-year low. It yields 5.6%. Unlike its peers, it is resorting to asset sales and new debt to fund its dividend. Exxon also is running counter to the rest of the industry by ratcheting up capital spending in an effort to sharply boost its daily energy production by 2025.
Analysts view Exxon’s dividend as safe. It’s a proud company that until a decade ago had the largest market value in the world. It’s a good bet that it will want to extend its streak of 37 straight years of annual dividend increases by lifting the payout in April (see story, page 33).
“We still favor Chevron over Exxon,” says J.P. Morgan analyst Phil Gresh. “Chevron has a strong balance sheet, a disciplined approach to capital allocation, and its break-even oil price to cover its dividend is much lower than Exxon’s.” While Exxon has some solid growth opportunities like Guyana, they are longer dated. Near-term earnings risk is still elevated.” Gresh has an Overweight rating on Chevron, with a price target of $135, and a Neutral rating and $72 target on Exxon.
Columbia’s King says Chevron’s dividend yield is about double the rate on its 10-year debt—one of the widest stock-bond yield gaps among major companies. “Chevron’s dividend is safe and very attractive,” King says.
Granted, there have been many false dawns for the sector in recent years. Barron’s has written favorably on the stocks, including a cover story in August. Yet investors probably should have some exposure to energy, and now may be a good time to get it.
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