Oil is at the lowest price we have seen in more than 10 years and there is no evidence that the price has bottomed. We believe the price crash for oil is very similar to what occurred in 1986, and the overall reason is due to a great increase of supply.
In 1986, the increase come from Saudi Arabia; today it is from the U.S. So how can investors play oil’s decline?
First, some background: from 1980 to 1986, OPEC decreased oil production several times to maintain high prices. Saudi Arabia went from producing close to 10 million barrels per day in 1980 to about 3.5 million barrels per day in 1985. OPEC was supposed to be on a quota system by country, but (no surprise) many members were cheating. In the fall of 1985, the Saudis became tired of losing market share, so they began greatly increasing their production.
Does keeping market share ring a bell with today’s headlines? This caused an oversupply and the price of oil dropped 67 percent between November 1985 and March 1986. The U.S. is now the swing producer in the world, with annual oil production up more than 80 percent since 2008. All this new supply has caused a devastating impact on price. Since June 2014, oil is down more than 60 percent. This has caused the price of most oil-related stocks to fall dramatically. For example, the Energy Select Sector SPDR ETF (ticker: XLE) is down 35 percent over the past year. With the steep decline in prices, many investors are looking to pick up some bargains, but in this regard, not all parts of the oil industry are equal.
The energy industry, as it relates to oil companies, can be broken down broadly into the following sub-sectors: exploration and production, service, refining and marketing and integrated companies. The integrated companies are the large companies that are most familiar, such as Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX). They have operations in practically all sub-industries. Taking these categories into consideration, here are a few things investors should keep in mind when looking for bargains in oil investments:
Not all oil sub-sectors are the same. Investors should resist the urge to buy the stocks that have fallen the most — the exploration and production companies and the service companies. Using 1986 as a guide, we find even after the price of oil had increased by more than 30 percent from its bottom, the integrated companies and refining and marketing companies greatly outperformed the other oil sectors.
Exploration slowdown. Exploration for new sources of oil will likely stay subdued until oil finds a new base price and trades in a tight range around that price for some time. Currently, most exploration and production companies are faced with large debts that will be maturing over the next year or two. They will likely remain in a price environment where many of them will go broke or be forced to sell to the larger integrated companies at bargain prices. If companies aren’t exploring and putting in new wells, the service companies suffer.
A refining advantage. In contrast to exploration and production companies, the refining and marketing companies have real benefits. They are not dependent on the price of the commodity. With a cheaper price for oil, they are able to expand their margins and demand for product.
If you are looking for bargains in the oil industry we suggest you focus on the large integrated companies and refiners. Consider an integrated entity, such as Exxon. The company has a stellar balance sheet and pays a dividend of 4 percent. For a refining and marketing company, take a look at Marathon Petroleum Corp. (MPC). The company trades around seven times cash flow and has a dividend yield of approximately 2.7 percent, which it has been been steadily increasing.
As of this writing, Bob Phillips owned shares of XOM, as do firm clients.
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How Investors Should Play Oil’s Decline originally appeared on usnews.com
