What should oil investors do after the drop?

Many energy stocks are at their all-time lows, but the discount provides opportunities for investors.

  • By Ellen Chang,
  • U.S. News & World Report
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Crude oil prices took a severe beating this year as demand dried up and inventory for oil and its related products rose exponentially, but investors have an opportunity to buy energy stocks at a steep discount.

Even a production cut of 9.7 million barrels per day starting in May agreed upon by OPEC members did not stem the continued decline of crude oil prices after a temporary bounce.

Other countries could also reduce production by as much as 10 million barrels per day since global fuel demand has dipped more than 30%. Companies such as BP (BP), Chevron Corp. (CVX), Occidental Petroleum Corp. (OXY) and ConocoPhillips (COP) have slashed production output.

Producing oil at less than $30 a barrel for the West Texas Intermediate benchmark means exploration and production companies are facing steep losses, but companies with clean balance sheets and low debt levels could be worth adding to a portfolio. The dip allows energy investors to take advantage of purchasing shares at lower prices.

A critical component is examining the break-even price for drilling oil. When crude oil prices drop below $30, many wells will go idle because they lose money to operate, says Rick Swope, senior director of investor education at E-Trade, an Arlington, Virginia-based brokerage company.

"This will have a residual effect on supply this year," he says. "While OPEC, Russia and other producers in a group known as OPEC Plus recently decided to curb oil production in light of supply and demand issues caused globally … there is concern that these cuts might not be enough to stop the bleeding of this sector."

Energy stock prices are impacted by the price of crude oil, production, usage and geopolitical issues, and face extreme volatility and risk currently.

"Although supply and demand matter in the long run, oil prices are technically determined in the futures markets," Swope says. "When traders expect crude oil supply to be limited, they buy more futures contracts, driving up the price of oil. In a sense, expectations determine reality."

None of the subindustries within the energy sector are "truly insulated from these macro headwinds," says Stewart Glickman, senior equity analyst at CFRA Research in New York.

"It's difficult to point to a single subindustry and say, 'Place your bets there,'" he says.

Investors should refrain from allocating money into the energy services sector, which includes drillers and oil-field services, because the lifeblood of these subindustries is "upstream (capital expenditures), and the outlook for upstream capex is atrocious," Glickman says.

These firms faced a grim outlook and were "lacking pricing traction even in 2019, and that was before oil prices fell apart and producers started slashing capital expenditures by a massive degree," he says.

"We expect upstream capex to be down 30% to 40% in 2020 barring a miraculous V-shaped recovery in oil prices," Glickman says.

The oil and gas storage and transportation sectors serve as a tollbooth for the industry, moving oil and gas from their locations to another one via pipelines and paying a flat fee per unit that does not vary with the value of the unit. Glickman has a neutral rating on this sector.

"If oil is $75 per barrel or $25 per barrel, it creates no direct impact for the pipeline," he says. "In most cases, they still receive the same flat fee. The risk for the pipeline is if the customers decide to stop moving as much volume as they did before, and so indirectly they are exposed to prolonged weakness in oil prices."

Energy and production companies with clean balance sheets and low debt levels will survive the downturn. Larger companies, known as the majors, will be able to continue drilling and producing oil at lower prices.

"Companies with relatively little debt today have a massive advantage," Glickman says.

Exxon Mobil Corp. (XOM) and Chevron each have net debt-to-capital ratios in the 10% to 11% range, which is very low. Given the size of these companies, they can "afford to borrow temporarily to help support their dividends," he says.

The capital markets are still accessible to them. Some with good balance sheets, such as EOG Resources (EOG) and ConocoPhillips, also should be able to manage.

Integrated oil companies are "the place to go," and it is prudent to stick with strong balance sheet names such as Chevron in integrated oil companies, HollyFrontier Corp. (HFC) in refiners and ConocoPhillips in E&Ps, says Mike Morey, chief investment officer at Integrity Viking Funds in Minot, North Dakota.

Midstream providers have been profitable in the past because they relied on external capital markets to supplement their own cash from operations because of the high outlays they make, Glickman says.

"They pay out hefty dividends, and they have an assortment of expensive multiyear projects that require a lot of growth capex," he says.

Companies that can rely solely on operating cash flow for all of their purposes remain at an advantage. One example is Kinder Morgan (KMI), which "can manage on its own," Glickman says.

"While it has oil exposure, it has a relatively larger business in natural gas logistics, and its yield of 6.7% is sustainable in our view."

Natural gas will be a relative winner, says Patrick Morris, executive vice president and director of Unicorn REH, a Dallas-based exploration and production company.

"Natural gas at $1.70 to $1.85 is very depressed and were it not for all of the residual gas from fracking, significantly below replacement cost," he says. "Since the industry is already pretty well rung-out, this new downturn might not be as painful."

The higher dividends that some energy companies are paying are particularly risky, David Trainer, CEO of New Constructs, a Nashville, Tennessee-based investment research firm, says in a research report.

"As oil and gas firms cut capital spending and delay or close down projects, those with already low profitability are at greater risk of cutting dividends to preserve resources," he says.

Occidental Petroleum has already significantly cut dividend payments by 86%, and Noble Energy (NBL) followed suit, slashing its dividend yield by 83%.

The energy industry is not expected to recover quickly, as demand levels will be dampened for an extended period.

"All of my comments above are predicated on a relatively dour outlook for oil prices that does not include a V-shaped recovery," Glickman says.

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