Buying Oil On The Dip? Stick To Buying Quality Oil Companies That Will Profit From A Rise In Oil Prices

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Includes: CVX, XOM
by: Ross K

Summary

Buying oil in the hopes that prices will normalize does not have strong risk/reward characteristics.

Chevron and Exxon present attractive buying opportunities.

Both companies are financially sound, diversified, and well-equipped to handle a further downturn.

Brent Crude Oil closed at a 5 year low of $57.88 despite news of supply problems in Libya that initially prompted an early spike in prices. And with oil prices at these lows levels, all anyone can talk about is how it's presenting an excellent buying opportunity. But who knows how long prices can stay at this level? OPEC has stood firm to produce this level of supply, and despite Venezuela's best efforts, that doesn't seem to be changing. With no end date to close out the trade in sight, buying oil-an asset with significant negative carry-seems like a risky bet at best, tying up your assets in the process. But there are better ways to put on a trade that would profit handsomely from a rebound in oil prices than just outright buying the commodity. One of these would be to buy an integrated oil services company like Exxon Mobil (NYSE: XOM) or Chevron (NYSE: CVX).

Both of these companies have excellent balance sheets flush with cash and very little debt. Exxon has about 5 billion dollars in cash on hand while Chevron has almost 14 billion. Their excess cash is very important in their ability to handle the oil shock; while the upstream (exploration and production) companies are having their profit margins slashed, these companies will not only be to use the cash to endure their reductions in profits, but can also use it to buy struggling fracking companies at steep discounts. In other words, Chevron and Exxon will be able to use the oil downturn as an opportunity to expand their businesses at bargain prices.

The companies are also trading at relatively cheap valuations. The oil slump is presenting an excellent buying opportunity: both companies are trading more than 10% from their 52 week highs. Exxon is currently trading at a P/E of 11.70 and Chevron at a P/E of 10.43, compared with the S&P 500 trading at a P/E of 21.4. Exxon is paying out a 2.97% yield in dividends, just under 35% of trailing 12 month earnings. Chevron is currently trading at a P/E of 10.43 and paying out a hefty 3.78% dividend, which is just over 39% of earnings. With both companies paying out less than 40% of their earnings as dividends, they both have plenty of room to increase shareholder value, either through an increase in dividends (both through growing earnings and increasing payout ratio) or share buybacks.

They both also have large downstream (refinement of crude oil and processing of natural gas) businesses which mean that even in the event that oil prices stabilize or even decline, both companies would still be able to generate significant profits from their refinement operations and distribution of natural gas products, which actually increase in revenue when oil prices fall. This diversification in business operations works as a hedge against a further decline in oil prices, which offers substantial downside protection.

In conclusion, a long position in crude oil is a precarious investment and has substantial negative carry (storage costs and forgone interest). Exxon and Chevron represent two excellent alternatives as they both will profit meaningfully from an increase in oil prices. But more importantly, they will reward you for holding them while you wait for the rebound to materialize; and if prices take a turn for the worse, their diversification will prevent them from falling steeply.

Disclosure: The author is long CVX, XOM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.