Are These Oil Producers A Buy?

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Includes: ARP, BP, CVX, PTR, TALO, TOT, XOM
by: Robinson Roacho

Summary

The crude oil production industry is recovering.

The World Bank forecasts a steady climb in crude oil price over the next 10 years.

Mean-variance portfolio optimization of the five largest oil producers.

There has been a general recovery in crude oil prices since mid-January after a long and steady decline in the commodity. The World Bank estimates that crude oil will trade around $42 per barrel in 2016 followed by a slow recovery during the next 10 years.

Several small companies will not survive the crude oil crisis and they will declare bankruptcy or will be taken over. Some of the companies I believe will not survive include Stone Energy (NYSE: SGY) and Atlas Resource Partners (NYSE: ARP). However, the outlook for big names is brighter. Companies such as Exxon (NYSE: XOM) and Chevron (NYSE: CVX) are likely to sail through the storm with flying colors. The stock price of some of these companies have not been as affected with the crude oil price drop.

Because I believe that the oil industry is touching the bottom, it is time to put together a shopping list with companies that offer a good excess return per unit of volatility. This article describes the mean-variance study of five of the largest oil producers as per market capitalization using the monthly returns for the past five years. These companies are Chevron, Exxon, British Petrol (NYSE: BP), PetroChina (NYSE: PTR) and Total SA (NYSE: TOT). Table 1 illustrates the average monthly return, variance and standard deviation of the oil producers along with the "Sharpe Ratio". The Sharpe ratio is calculated by subtracting the average monthly return minus the average monthly 10-year Treasury bill yield (0.167%).

Average Monthly Return

Variance

Std. Deviation

Sharpe Ratio

XOM

0.63%

0.001798

4.24%

0.110366

CVX

0.51%

0.003116

5.58%

0.062182

PTR

-0.48%

0.005847

7.65%

-0.08473

TOT

0.65%

0.003761

6.13%

0.078174

BP

0.45%

0.005011

7.08%

0.040103

Table 1

Portfolios

The portfolio with the highest Sharpe Ratio is formed by 85.7% in XOM and 14.3% in TOT. The average monthly expected return is 0.64% and the standard deviation is 4.19%. This portfolio has a Sharpe ratio of 0.112. This is the portfolio that you must select regardless of your risk appetite.

If you are a risk lover and your only concern is return, you should have a long position in TOT only. The average monthly expected return is 0.65% and the standard deviation is 6.13%. In my opinion, the higher standard deviation of 2% does not justify a 0.01% excess return over the efficient portfolio.

An equally weighted portfolio produces an average monthly expected return of 0.35% and a standard deviation of 5.2%. The Sharpe ratio is 0.036.

Portfolios

Equal Wt.

Max Return

Min Std Dev

Max SR

Containing Variable

None

σ <=

E[r] >=

None

Value of constrain

None

4.24%

0.65%

None

Portfolio Weights

XOM

20.0%

74.7%

0.0%

85.7%

CVX

20.0%

0.0%

0.0%

0.0%

PTR

20.0%

0.0%

0.0%

0.0%

TOT

20.0%

25.3%

100.0%

14.3%

BP

20.0%

0.0%

0.0%

0.0%

Portfolio

100.0%

100.0%

100.0%

100.0%

E[r]

0.35%

0.64%

0.65%

0.64%

Std Dev

5.20%

4.24%

6.13%

4.19%

Sharpe Ratio

0.036

0.111

0.078

0.112

The following graph illustrates the position of each portfolio and stock in the risk/reward zone. The idea is to aim for portfolios or stocks close to the upper-left corner. XOM and the Max Sharpe Ratio portfolio are very close together. Therefore, the XOM point has been deleted for visual clarification purposes.

In brief

I believe that the oil industry is transitioning into the recovery phase. Therefore, it is a good idea to start putting shopping lists together and look for entry points. While many small companies will perish, large companies will fare better. The mean-variance optimization strategy suggests that long exposures to CVX, PTR and BP will not help diversify you portfolio because the risk/reward is bad. Instead, your position in the oil industry must be composed of a large stake in XOM and a small stake in TOT. The percentages in these stocks depend on your investment goals.

Supporting Documents

  1. Oil_Mean-variance.xlsx

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.