The 2 Keys To Successful Big Oil Investing

by: Tim McAleenan Jr.

Lately, I have been celebrating the fact that excellent companies tend to raise their earnings every year. In particular, I have pointed out that Johnson & Johnson (NYSE:JNJ) has raised its earnings every year since 1997, and Coca-Cola (NYSE:KO) and Procter & Gamble (NYSE:PG) tell similar stories, although you can find a year or two when the earnings fell a couple cents per share if you look hard enough. Of course, not all companies give their investors such near linear growth.

Today, I want to discuss investing in a sector that is far more volatile (earnings wise) than the typical consumer staples, consumer discretionary, conglomerates, and large-cap healthcare stocks that I typically discuss. That, of course, would be the energy super majors: Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), Total SA (NYSE:TOT), Royal Dutch Shell (NYSE:RDS.B), and BP (NYSE:BP).

Obviously, the price of a barrel of oil effects the profitability of each of these companies. From 2007, to 2008, the price of oil went up from $64 to $91 per barrel. These companies earned record profits. Then, the price of oil fell from $91 in 2008 to $53 in 2009. As you can guess, this caused the profits at each of the energy super majors to plummet.

When we study the 2007-2008-2009 sequence, we can learn two things that can shed insight on whether you have the right temperament and technique to become a successful long-term investor in the energy super majors.

The first thing you should keep in mind is that traditional valuation metrics like P/E ratios are of limited use when dealing with businesses in cyclical industries that are as volatile as commodities. Some people call this the "earnings valuation trap" because, when earnings are strong at the top of the business cycle, the P/E seems to be low. Likewise, when earnings plummet and the P/E ratio is high, that is often the time you should be buying.

In Exxon's case, the company earned $8.98 in 2008. The price reached $96 per share. Considering that a 15-year analysis of the company would indicate a historical P/E ratio of 11, the stock may have appeared slightly undervalued when it was trading at a P/E ratio of 10.69. But as we now know, that is the worst time this past decade that you could have bought Exxon's stock, and the price today of $88 per share still hasn't reached its 2008 high. The P/E ratio would have deceived you quite a bit.

Likewise, when 2009 hit and oil fell to the low $50s, Exxon's earnings collapsed to $3.98 per share. Exxon spent a lot of that time trading in the $62-$72 range. If you were making your investment based on the current earnings of the company, you would have seen a P/E ratio of 15.57 to 18.09. To investors using historical P/E metrics, Exxon would have seemed rather overvalued, appearing as if investors had lost their minds and were paying 1.5x what the company typically traded at.

Of course, as we know, this would have been a great time to buy Exxon, despite what the P/E ratio suggested. That's why energy investing, in particular, is more art than science. You have to make probabilistic guesses about what the company will be earning and paying out to shareholders over the course of a business cycle to get a handle on what would be a rational price to pay today.

The second thing long-term energy investors need to make peace with is the volatility of earnings. If you want to see linear earnings that seem to go up just about every year, then you should probably stick with something like Colgate-Palmolive (NYSE:CL) [and by the way, that's no grave hardship, as this excellent real-life article from David Crosetti points out].

Here is what happened from 2008 to 2009:

Exxon's earnings fell from $8.69 to $3.98. However, the dividend grew from $1.55 to $1.66.

Chevron's earnings fell from $11.67 to $5.24. However, the dividend grew from $2.53 to $2.66.

Royal Dutch Shell's (NYSE:RDS.A) earnings fell from $10.16 to $4.08. The dividend increased from $3.13 to $3.36, however, it remained static for two years thereafter.

Conoco's earnings fell from $10.66 to $3.24. The dividend went from $1.88 to $1.91, because Conoco announced a quarterly increase from $0.47 per share to $0.50 per share in the last quarter of 2009.

BP's earnings fell from $8.17 to $4.47. The dividend grew from $3.30 to $3.36.

Total SA's earnings fell from $8.55 to $5.31. The dividend grew from $3.10 to $3.28.

When the price of a stock falls, I encourage investors to focus on the operational results of the company. Usually, I do this within the context of talking about Coca-Cola, Johnson & Johnson, Procter & Gamble, etc. With companies like that, the earnings are still chugging along nicely (and the dividends are going up) even if the stock price is going down. That is not the case here. When the price of oil falls and the price of oil stocks fall, you will actually see the operating results of your company fall, perhaps even substantially. Looking at the 2008-2009 transition point, you should ask yourself: Can I handle the bottom of a commodity business cycle when earnings get cut in half? If you cannot answer that question with a resolute yes, you might be putting yourself in a position to sell low.

If you are considering the purchase of energy super majors, those are two important things to keep in mind. You can get pretty far with the "Reversion To The Mean" principle with a company like Coca-Cola by saying "this company will usually trade at a P/E ratio of 20." You can't really talk like that when it comes to energy companies. You have to look at total current and future production and make guesses about commodity prices that will influence the value of that production.

Additionally, the march will not be upward. You're not going to get guaranteed earnings growth every year (although, in the case of Exxon and Chevron, you should get guaranteed dividend growth every year). You have to think in terms of: "Earnings and dividends will be noticeably higher over most five-year periods, unless we're approaching/exiting the bottom of a business cycle." Some investors can handle that kind of thinking better than others. If I were considering the purchase of an energy super major for the long-term, those are the kinds of factors that would influence my decision of whether to make energy purchases or not.

Disclosure: I am long BP, JNJ, COP, PG, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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