If You Regretted Not Investing More In 2008, Invest In Oil Now
- If you regretted not investing more in 2008, there are quality oil companies trading for a lower P/E ratio today that you can invest in.
- Covid-19 fears have become overblown, especially in terms of market punishments. Even in a worst case scenario markets are undervalued.
- I recommend investing in the three companies discussed below. Let me know what you think in the comments!
- I do much more than just articles at The Energy Forum: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »
Stock prices fluctuate on a day-to-day basis. Throughout all of this fluctuation, it's important to remember that what you're buying isn't a piece of paper, it's a share of a company. As a shareholder in a company, you're entitled to an equivalent percentage of its profits, expenses, and more. 2008 was a prime example of how investors can overreact, if you invested in 2008 you'd be sitting on >350% gains.
No industry has been punished more recently than oil companies. These undervalued companies have significant potential to reward shareholders. As we'll see throughout this article, ExxonMobil (NYSE: XOM), Gran Tierra Energy (NYSEARCA: GTE), and Occidental Petroleum (NYSE: OXY) are three companies with the ability to generate significant shareholder rewards if you invest today.
S&P 500 P/E Ratio - Macro Trends
As earnings recovered, but share prices didn't, market P/E ratios hit their lowest in decades at 13 in 2011. Since then, they've almost doubled. If you invest today, you're getting, on average, less than a 4% earnings yield. This is in a market where, in 2019, the S&P 500 had 0.7% YoY earnings growth, forecast at, before COVID-19 slowdowns, 7.8% in 2020.
In an expensive market, it pays to see the opportunities. Buying banking stocks at the bottom of 2008 could have yielded numerous 10-baggers. Even the Vanguard Financial ETF (NYSEARCA: VHT), is up almost 450% since its 2008 lows. The equivalent opportunity today is investing in oil markets.
Oil Market and COVID-19 Scenario
Oil markets are currently getting devastated, that's no secret. A choice Seeking Alpha news piece discussed how energy markets are down 18% YTD. That was yesterday. Today, it's more than 20%. On Monday, it was just over 15%. The downturn shows no sign of slowing down, with futures down over 1% on the previous comments.
In the oil market scenario, prices have dropped significantly. Bloomberg was the first to publish a story about China's oil demand. For those who don't know, China is the world's largest oil importer. That 20% decline in oil consumption was a massive 3 million barrel / day decline in consumption. OPEC continues to sit on its hands, without a production cut.
That's in spite of the virus popping up in OPEC's own backyard. Iran either has a debt rate that's 10x every other country with the virus, or its under reporting cases. The genuinely opinion is that Iran is under reporting cases. It's worth paying close attention too - Iran has already spread the virus to several nearby countries.
Many of these countries, like Syria and Iraq, have poor healthcare systems and porous borders.
Simultaneously, South Korea has passed more than a thousand cases, the largest outbreak outside of China. The cultist church members are still being tracked down. Italy has the largest outbreak in Europe, with several hundred cases, that's now spreading across the remainder of Europe. The CDC warned that not only is the U.S. unprepared, but it should consider person to person spread likely.
It seems increasingly like that this virus, with its 2% death rate, versus 0.002% for the flu will go global with yet to be seen ramifications. Investing, at this time, might be scary.
Yet there's good news. Gilead Sciences (NASDAQ: GILD) went up significantly on the news of 2 Phase 3 trials for COVID-19. Human testing of a new vaccine could start soon, and is expected to peak at the 1 year mark. Assuming the trial can be stopped from spreading globally over the next few months, there's real potential to stop it.
Oil Supply and Demand Balance - Oil & Gas Journal
The above graph shows the demand / supply balance of oil and gas. It's worth noting this doesn't count the effects of COVID-19. However, with that said, it also doesn't count the affects of an already decided 500k barrel / day OPEC cut, with the potential for additional OPEC cuts. China is slowly returning to work, meaning that 3 million barrel / day decline can return.
The question is how significant can this oil drop get. Let's look at a massive worse case. Worldwide quarantines result in oil demand dropping by several times China's drop - 10 million barrels / day. OPEC cuts eat up 1 million barrels / day. The net change, over the next 3 months, is 810 million barrels of oil not consumed.
It's worth noting that such a massive virus and quarantines will also likely result in oil production dropping dramatically. We will assume that, in 3 months, the outbreak will have played itself out - either through people getting the disease or through a vaccine / cure. That 810 million barrels extra is just over 1 week of production.
It'll need to be sold. However, it will not be a permanent punishment to oil prices. And that's what investors should recognize. Regardless of how COVID-19 plays out, even if it kills 1-2% of the world's population, that doesn't justify a >20% long-term decline in oil prices, and an even larger decline in share prices.
As a result, through that panic, there are a number of quality investment options. As the P/E ratio of oil companies goes lower than the lowest P/E ratio of the market over the past 20 years, investing in quality income based companies has significant potential. Let's discuss (3) companies that I highly recommend.
These companies are ExxonMobil (NYSE: XOM), Occidental Petroleum (NYSE: OXY), and Gran Tierra Energy (NYSEARCA: GTE). For investors interested in putting these companies together into an income generating investment portfolio, I recommend checking out The Energy Forum.
Starting with ExxonMobil (NYSE: XOM), the company has been punished heavily for the oil crash, reaching lows not seen since the early-2000s. This is despite a 50+ year history of increasing dividends. The current dividend yield of more than 6.5% is higher than the expected S&P 500 growth, not counting any appreciation.
ExxonMobil Earnings Potential - ExxonMobil Investor Presentation
ExxonMobil is in a high investment period. The $180 billion it plans to invest in its business from 2020-2025 is near its present market capitalization of $220 billion. The returning will be significant, and the company's Permian Basin and Guyana investment (Phase 2 Guyana breakeven is a mere $25 / barrel) will support the upside.
As a result, by 2025, the company is anticipating earnings reaching almost $40 billion. Even in a $40 / barrel environment (almost 30% below today's prices in our current COVID-19 fear environment) earnings will reach almost $30 billion (40% growth). As an investor, you're buying a share of a $220 billion company, that pays out $14 billion / year in dividends.
You collect that 6.5% dividend to wait. And by 2025, you'll own a stock, that based on your cost basis, even if oil prices drop 30% between now and then, will have a P/E ratio of <8. It doesn't get much better than that.
Occidental Petroleum (NYSE: OXY) is another name that's been punished heavily by the markets, especially after investor fears over debts from its Anadarko Petroleum acquisition (and financing plan with Warren Buffett). Here the results are even more astounding as the company's dividends have been pushed to >9%.
Occidental Petroleum Shareholder Returns - Occidental Petroleum Investor Presentation
This is in-spite of a company with a long history of returning cash to shareholders. Since 2002, the company has returned more than its current market capitalization to shareholders. More importantly, it has continued to pay and grow its dividend through difficult time periods (2008). The company has indicated its dividend is important and doesn't intend to cut it.
The company has layered its portfolio so that its dividend is long-term sustainable at $40 WTI. The company underwent a "cost-less" hedging program that limited oil price upside to ~$74 / barrel but provided it with basically + $10 / barrel on current oil prices in its sales for 2020-2021 (enough to cover the dividend and debt).
WTI prices would need to fall another near 25% for things to start getting concerning. And they'd need to stay there. There is some risk to the dividend if oil prices do drop and remain low, along with the company not being able to undertake asset sales. However, this risk is low, even with all the recent COVID-19 fears, oil prices are well above this.
Additionally, a 50% dividend cut, which would save more than $1 billion / year, would still provide investors with a near 5% yield.
Gran Tierra Energy (NYSEARCA: GTE) is another small cap company that's been punished heavily. Small-cap companies are especially interesting because they tend to be punished more than the rest of the market, even if their financials aren't worse, and Gran Tierra Energy is a classic example. It's the class deep-value player members of The Energy Forum hear about regularly.
Gran Tierra Energy Outlook - Gran Tierra Energy Investor Presentation
The above image shows the company's previous cumulative 5-year and 10-year outlook at $60 Brent. Now I don't want to be naive, crude prices are currently ~$8 / barrel below this. Given the company's 5-year outlook involves ~40 thousand barrels / day of production, that $8 difference is $580 million - assuming COVID-19 years remain constant.
However, ~$120 million of that $580 million will come from income taxes, and royalties and various fees will also be lower. Counting that, we're still left with ~$900 million in 5 year discretionary FCF (the company's net debt is $630 million). What this means is, not only could it cover its entire debt (or choose to pay interest), but after it repays debt it could repurchase 100% of its shares.
That's because the company's current market capitalization is <$300 million. To put this more succinctly, in 2020, the company's Brent breakeven is <$35 / barrel. It plans to focus on debt reduction, but at current prices, it should heavily repurchase shares. Even with oil price reductions, 2020 discretionary FCF should be >$200 million.
That's enough to repurchase almost 70% of the company in one year, while paying all other expenses.
The opportunities don't get much better than that! As I hope is clear from this discussion, the number of low price quality energy companies on the market is significant. I recommend investors, those who regretted not investing in 2008, take advantage of this market to invest.
Of course any portfolio and investment has risks. This is no different. As we saw from ExxonMobil (best in breed), Occidental Petroleum, and Gran Tierra Energy, all of these companies need oil prices of ~$35-40 / barrel to truly be successful and generate acceptable shareholder returns. That's 40% below current prices but prices have fallen there before in early-2016.
The fact that these prices are below the breakeven of many producers means it's unlikely they'll fall there again and stay there. However, it'd be naive to thing that they couldn't. And if they do, investors in these companies would take big hits. So it's always worth keeping commodity prices in mind as you do.
Fortunately, you can hedge these risks. Airlines and cruise companies (like Carnival Cruises, NYSE: CCL) have been heavily battered by COVID-19. If the virus goes away, but oil prices don't recover, these companies should reach new record profits as fuel, one of their biggest expenses, remains cheap. Investing in these stocks can help hedge the risk of low oil prices in a scenario where COVID-19 is fixed.
Another risk worth paying attention to in the oil sector is operation risks. ExxonMobil is undergoing a massive capital investment program to the tune of $30 billion / year for the next 6 years. With recent dips in market capitalization, over this 6 year time period, ExxonMobil will be spending almost its entire market capitalization on investments.
Obviously, there's significant risk that if these investments don't achieve the ROIC that the company anticipates, shareholders would have spent significant money with minimal benefits.
The last risk worth paying attention to is that oil markets are going through a potentially systemic decline. The prospect of peak demand is seen as getting more and more real each day. While that doesn't mean a disappearance of oil, especially with potential production cuts from OPEC, it does mean there will be potential pricing pressure.
Overall, the markets can be scary places with significant risk at times. However, despite this risk, there is significant opportunity to be had for investors who are willing. Nowhere is this more evident than in the current environment with COVID-19 fears and oil stocks.
However, with that said, there are a number of available quality investment opportunities. ExxonMobil, with its investment, will be trading at a P/E ratio of less than 8 by 2025. Occidental Petroleum has a secure, thanks to hedging, double-digit yield. Gran Tierra Energy is earning enough to repurchase nearly 70% of the company in a year. These are all quality undervalued investments.
At The Energy Forum, we offer a 2 week risk-free trial and specialize in building an income portfolio of quality companies in difficult times. What are you doing to invest during this time? Are you selling your stocks? Let me know what you think in the comments below.
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