Energy stocks have rarely been this unloved. Investors are missing out.
On the surface, the case for energy stocks has worsened in recent months as the escalating U.S.-China trade war and other geopolitical disruptions have heightened concerns about global growth and energy demand. A potential sign of recession called an inverted yield curve flashed just this past week, with the yield on the benchmark 10-year Treasury falling below 1.6%, less than the two-year note.
Underlying commodity prices haven’t done much to inspire investor confidence, either. U.S. oil prices have fallen to around $55 a barrel from an April high of $66. Natural gas has also been hit hard, down more than 25% this year, to the lowest level since 2016.
The SPDR S&P Oil & Gas Exploration exchange-traded fund (XOP) touched a record low earlier this month, and is off 20% for the year to around $21 a share. The weighting of energy in the S&P 500 index (.SPX) has dropped below 5%—the lowest it has been in at least the past 40 years and less than half the 13% level reached in 2008, when oil peaked above $140 a barrel—as investors have bid down share prices.
Now, with Wall Street abandoning the sector and seemingly capitulating, the group may be bottoming out. Energy-stock valuations have come down this year and are below their long-term average. And many industry players are responding to investor pressure to rein in capital spending, curb supply, boost returns, and pay out more to shareholders in dividends and stock repurchases.
What’s more, even if there is a global growth slowdown, near-term oil demand isn’t likely to fall much, if at all. Demand has risen steadily in recent decades, showing resiliency even during deep recessions such as the one that accompanied the financial crisis.
As a result, investors can now get dividend yields above 6% on the two European supermajor stocks, Royal Dutch Shell (RDS/B) and BP (BP). An out-of-favor Exxon Mobil (XOM), at around $67.25, yields 5.2% and trades where it did a decade ago. Chevron (CVX), regarded by many analysts and investors as the best positioned of the majors, trades around $117 and yields 4.1%.
“Oil is not going the way of tobacco, but in the mind of the market it might as well be,” says Paul Sankey, an energy analyst at Mizuho Securities, referring to how out of favor the sector has become among socially responsible investors and others.
He has urged energy companies to emulate cigarette makers and pay out more of their earnings in dividends and stock buybacks. Given long-term demand uncertainties facing the industry, energy companies of all sizes should be paying out dividends that are at least as good as the nearly 2% yield on the S&P 500, he says.
Still, it is hard to find big fans of energy stocks, even among investors focused on the sector. That’s understandable, given that energy is by far the worst-performing group in the S&P 500 over the past decade, with an annualized return of 4.4%, against 14% for the index. Continuing that trend, energy is bringing up the rear in the S&P 500 this year, with a loss of 1.2%, versus a 15.2% gain for the broader index.
“With energy just 4.7% of the S&P 500, generalist [fund managers] can ignore it, just like materials and utilities, which are 3% of the index,” says Mark Stoeckle, senior portfolio manager at Adams Funds, who runs the energy-heavy Adams Natural Resources fund (PEO). The $450 million closed-end fund, whose largest holdings are Exxon, Chevron, and EOG Resources (EOG), trades at about $15, a 17% discount to its net asset value, and offers a play on the sector’s revival. It yields 3.1%.
Another broad way to play the sector is the Energy Select Sector SPDR (XLE). This ETF is dominated by Exxon Mobil and Chevron, which account for nearly half its assets. It trades around $56 and is down 2% this year, yielding 4.1%. The SPDR S&P Oil & Gas Exploration ETF includes among its top holdings the energy producers Noble Energy (NBL) and Hess (HES), as well as a group of refiners. It yields less than 2%.
Growth-stock investors see little need to hold energy, Stoeckle adds. The sector is now down to 1% of benchmark growth indexes such as the Russell 1000 Growth (.RLG).
The Tesla (TSLA) effect is also weighing on the energy market, Mizuho’s Sankey says, as investors look to a day when electric vehicles will become widespread and cut into oil demand. It doesn’t matter that the penetration of electric cars is trivial now, because investors figure that electric cars will ultimately dominate, even if it is decades from now. “The market wants to be long the future, which is technology,” he says.
Another negative is the growing adoption of socially responsible investment guidelines, particularly in Europe. European climate-change activists have assailed energy companies as perpetrators of global warming and pressured cultural organizations not to accept contributions from Big Oil.
Mark Rylance, one of Britain’s leading actors, resigned from an honorary position at the Royal Shakespeare Company because it accepts money from BP in order to provide discounted tickets for schoolchildren. “I do not wish to be associated with BP any more than I would with an arms dealer,” Rylance wrote in his resignation letter. “Nor, I believe, would William Shakespeare,” he added.
One contrarian who is bullish on the oil market is Michael Rothman, a veteran commodities analyst who runs Cornerstone Analytics. He believes that the global oil market will tighten further. Inventories will be drawn down in the coming months, and Brent crude—the international benchmark now around $58 a barrel—could hit $90 by year’s end, he says.
“Many market watchers want to assume that OPEC has almost three million barrels a day of spare capacity, but it doesn’t,” Rothman says. “And demand, up until very recently, has been more robust than most realize.” He estimates that the Organization of the Petroleum Exporting Countries’ spare capacity is just over one million barrels a day—a fraction of the 100 million barrels in global demand a day. U.S. oil-production growth, meanwhile, has slowed.
Exxon Mobil anticipates that oil demand will continue to rise for the next two decades, an estimate supported by consumption trends, population growth, and rising living standards in the developing world (more cars and air conditioners). Chevron, which has a similar forecast, estimates that the industry will have to spend $10 trillion through 2040 to replace oil reserves and meet demand.
Rothman’s view is that oil demand, which is dominated by transportation, will stay steady despite price moves. “Oil demand has contracted only twice in the past 35 years,” he says, noting that the biggest decline, during the 2009 downturn, was only about 1% globally.
Here is a closer look at several energy sectors:
Among the major multinational oil companies, Chevron has set the standard on capital expenditures and shareholder returns, with Royal Dutch Shell not far behind.
After the completion of some major energy projects around the world over the past few years, Chevron expects to hold capital spending to $20 billion annually in the coming years —half its 2013 peak—while expanding energy output at a 3% to 4% yearly rate. Chevron has one of the leading positions in the Permian Basin oil fields in Texas and New Mexico and plans to double production there by 2023, to 900,000 barrels a day.
Chevron, which had struck a $33 billion deal to buy Anadarko Petroleum in April, walked away with a $1 billion breakup fee when it wouldn’t get into a bidding war with Occidental Petroleum (OXY). That move looks smart, given the 20% drop in oil prices and the selloff in the energy sector since then. “Chevron is executing well,” Stoeckle of Adams Funds says. “The discipline it showed in walking away from Anadarko was impressive.”
Chevron shares currently yield 4.1%, and the company is buying back about $5 billion of stock a year.
Shell also impressed investors earlier this year when it projected that it could return $125 billion—or more than half its current market value—in cash to shareholders in dividends and stock buybacks from 2021 to 2025. Some of the bloom has come off the story since the British-Dutch company’s second-quarter earnings came in about 20% below expectations. But analysts attributed the shortfall, in part, to several one-time factors as well as weakness in the global chemical industry.
“Royal Dutch is a great value,” says TVR Murti, a portfolio manager at Pzena Investment Management. “The company should generate a phenomenal amount of cash flow in the next few years” as it begins to see a payoff from completed projects, he says.
Both its class A and class B American depositary receipts trade around $55. The less-liquid B ADRs (which are formed from the U.K.-listed shares) could be a better bet for U.S. holders since the 6.8% dividend isn’t subject to U.S. withholding taxes. The class A ADRs (the Dutch shares) are subject to a 15% withholding tax. The company now has a total yield—dividend plus buybacks—of around 10%.
Once the industry favorite, Exxon Mobil has suffered from weak energy-production trends and earnings woes. Its second-quarter net income of 61 cents a share was about 5% below the consensus estimate, and the company had to borrow $4 billion to help cover its dividend.
And while much of the industry is curtailing or holding the line on capital spending, Exxon is boosting it to more than $33 billion by 2020, from $26 billion last year. The increase is part of an ambitious effort to boost production, now below four million barrels a day, to five million barrels a day by 2025.
“We’re not as concerned as the marketplace that the capital spending is higher than peers,” Murti says. “We think the investments will pay off.”
Exxon CEO Darren Woods contends the spending is justified by the quality of the projects, notably a huge offshore oil field in Guyana. Exxon, whose shares trade around $67.25, yields 5.2% and has one of the industry’s best balance sheets. The stock, however, isn’t cheap based on earnings, trading for 20 times projected 2019 profits of $3.32 a share, a premium to its supermajor peers.
Canada’s energy stocks are arguably more depressed than their U.S. counterparts.ke Suncor Energy (SU), whose stock is off nearly 30% in the past year. Its U.S. shares trade around $28, yield 4.6%, and are valued at 11 times projected 2019 earnings. The company is a top producer in the Alberta oil sands, making it a target of environmentalists who decry the dirty extraction process.
Yet Suncor has less risk than other major oil companies because its enormous oil-sands reserves—equal to more than 30 years of production—make it more of an oil manufacturer than an exploration company. The company is a favorite of Mizuho’s Sankey, who wrote recently that Suncor amounts to a “differentiated story” with “capital discipline, cash return to shareholders, and the power of integration.” Suncor also operates a large refining business that Sankey calls the best in North America. He has a $40 price target.
Crescent Point Energy (CPG) illustrates the woes of smaller Canadian producers. Its U.S. shares are down 90% over the past five years and now trade around $3, for a market value of $1.5 billion—below the value of its proven energy reserves. Crescent has a low valuation, at six times projected 2019 earnings, and annual free cash flow of about $350 million that it’s using for debt reduction and stock buybacks. Its shares yield 1.1%.
U.S. E&P companies
As investors focus on free cash flow rather than production growth, exploration-and-production stocks have suffered. But they look appealing based on traditional price/earnings ratios, with EOG and Pioneer Natural Resources (PXD) trading for 12 times projected 2020 earnings. There’s also the possibility of acquisitions by oil majors.
EOG, long viewed by analysts as the class of the sector, has fallen 34% in the past year to $75. Reflecting its ambitions, EOG says it aims to be one of “the best companies across all sectors of the S&P 500, with double-digit returns and organic growth.” Its oil production rose 18% in the second quarter.
Sankey is a fan, calling EOG the Apple of the E&P sector, thanks to what he views as its technological edge in finding and producing crude. And he has a Buy rating with a $122 price target.
EOG’s dividend is up sharply in recent years to 1.5%, and the company targets 2%. Sankey thinks that’s still insufficient. “If management thinks that an oil company with a 2% yield is attractive relative to the S&P 500, they are misguided,” he wrote. “Stocks such as Occidental Petroleum, which is arguably performing as well as EOG in the Permian, are trying to attract investors with 6% yields.”
Pioneer, whose shares are down 28% to $123 in the past 12 months, trades for six times earnings before interest, taxes, depreciation, and amortization, or Ebitda, down from 15 in 2017. It has a huge and valuable base of undeveloped land in the prime Midland region of the Permian basin, and is viewed as a takeover candidate for Exxon Mobil, which has made the Permian one of its priorities.
With former CEO Scott Sheffield back at the helm, Pioneer recently announced a cut in 2019 capital expenditures, a near-tripling in the dividend to $1.76 annually (1.4% yield), and $200 million of second-quarter stock buybacks (equal to about 1% of the shares outstanding).
Occidental is an intriguing play following a 30% drop in its stock after rumors surfaced in April of its interest in Anadarko Petroleum. Its bet-the-company move in May to outbid the much larger Chevron and to take on expensive financing from Berkshire Hathaway (BRK/B) to avoid a shareholder vote, hasn’t played well with investors. It has attracted activist Carl Icahn, who has blasted the board and Occidental CEO Vicki Hollub.
Occidental says the $37 billion (or $55 billion including debt) transaction makes strategic and financial sense, although the added debt makes the company vulnerable to weaker oil prices—which has driven down the stock lately. If Occidental stumbles, Hollub could be gone as CEO and the company put up for sale, with Icahn arguing it would be worth much more than its current price to an acquirer.
Occidental stock, around $44, yields 7.2%.
Oil services and drillers
A slow recovery in global drilling activity and pricing pressures in North America have weighed on energy-service titans Schlumberger (SLB) and Halliburton (HAL). But both stocks look attractive as company executives rein in capital spending to boost free cash flow.
Halliburton, at $18, trades around 14 times projected 2019 earnings, and Schlumberger, at $32, fetches more than 20 times 2019 profits. Schlumberger executives have expressed confidence in the company’s $2-a-share dividend, which provides a yield of more than 6%. Halliburton yields 4%.
Transocean (RIG) and Diamond Offshore Drilling (DO), which lease drilling rigs for offshore energy production, have been hurt by diminished activity and a drop in leasing, or day, rates. A hoped-for revival has been slow to materialize, with Diamond’s management saying on its recent earnings conference call that the upward trend in leasing rates has been disappointing.
Diamond shares are now around $5.50, while Transocean’s are around $4. Both are down 80% from 2014 highs. Neither company pays a dividend.
“While we await signs of a meaningful pickup in tendering and day rates, the drillers were candid in their assessment of the [deep-water drilling rig] market, confirming the recovery is being pushed out at least one year, to 2020,” Barclays analyst David Anderson wrote recently. That also pushes out a return to profitability, with Diamond and Transocean expected to operate in the red in both 2019 and 2020.
The stocks amount to leveraged plays on higher oil prices. If investors see meaningful improvement in day rates, the stocks could double.
The group may be the worst performer in the market this year, with many stocks down 50% or more. Put simply, with natural-gas prices recently at $2.15 per million British thermal units, the industry needs higher prices. The futures markets aren’t optimistic, pegging gas prices below $3 per million BTUs into the early part of the 2020s.
Production growth, however, is getting curtailed, with most of the industry now operating in the red. The old saying in commodity markets may hold true: “Low prices are the cure for low prices.”
Cabot Oil & Gas (COG), operating in the prolific Marcellus Shale region of Pennsylvania, cut its 2019 production outlook in conjunction with its second-quarter earnings and now sees just 5% growth next year. Its free cash flow, once projected at $600 million for 2019, is melting away at current prices.
Cabot, at $16, is down 27% this year, but has staying power thanks to low production costs and one of the best balance sheets in the sector. Range Resources (RRC), at $4, is off 57% this year and Southwestern Energy (SWN), under $2, is off about 50%.
Cabot and Range yield about 2%, while Southwestern pays no dividend.
Investors have warmed to the refining sector in recent years because of its ample margins, disciplined capital spending, and capital returns.
With crude products such as gasoline and diesel fuel most exposed to electric cars, why have refiners been the best group in the energy patch in the past few years? “Cash returns are so high,” Sankey says. “Investors are indifferent to the outlook beyond 10 years.”
There has been some pressure on the stocks this year as refining margins narrowed. Valero Energy (VLO), at $77, yields almost 5%; and Phillips 66 (PSX), at $98, yields 3.7%. Both have moderate buyback programs resulting in total yields in the high single digits.
From the more-secure energy majors to the speculative gas stocks, there appears to be a gusher of opportunity in the stock market’s most depressed sector.
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