Pros And Cons Of Investing In Oil Stocks

Summary

• What are the pros and cons of investing in oil stocks, is it too late to buy oil stocks, and what oil stocks to buy?
• In this article, I synthesize industry fundamentals and Seeking Alpha quant ratings to derive an answer to each of these questions.
• The pros seem to dominate the cons of investing in oil stocks at this time. We are still in the early innings of a major oil bull market.
• Measures to mitigate the cons of investing in oil stocks are also explored, for those who invest for a stable and growing income and those in search of capital appreciation.
• Looking for a helping hand in the market? Members of The Natural Resources Hub get exclusive ideas and guidance to navigate any climate. Learn More »

Bet_Noire/iStock via Getty Images

During the COP 26 UN climate change conference held from October 31 to November 12, 2021, in Glasgow, U.K., oil producers from Saudi Arabia to Shell (SHEL) were not welcome. Only two months ago, it was 'criminal' to produce oil and gas in Europe, bemoaned Eni SpA (E) CEO Claudio Descalzi.

Then, the Russian invasion of Ukraine changed everything. The crown prince of Saudi Arabia Mohammed bin Salman Al Saud was implored by western leaders to produce more oil. Oil executives in Houston were accused of unpatriotic act of not using the record profits to pump more oil.

More and more investors now ask whether they should invest in oil stocks or not, if it is too late to make an entry, and what stocks to buy.

The pros of investing in oil stocks

Oil stocks are a good investment at this time

I believe the merits of investing in any stock, or the lack thereof, should be assessed based on three criteria:

• Does the company own high-quality assets, the product from which will be needed by human beings in 10, 20, and 30 years, and which generate enough profits across industry cycles such that a high rate of return can be had?
• Is the business run by an able and shareholder-friendly management?
• Can I buy it at significant discount to its conservatively-estimated intrinsic value?

Firstly, oil and gas will continue to be used for decades to come. Elon Musk said, “If there was a button I could press to stop all hydrocarbon usage today, I would not press it.” Musk knows the mining equipment used for extracting nickel and lithium for Tesla EV batteries will stop humming without diesel. He knows many drivers will not be able to recharge their Tesla without the base-load electricity generated at coal or natural gas-fired power plants. It will take decades to replace hydrocarbons with renewable energy.

In 2021, the first year after oil companies came out of the worst bear market in its 175-year history, five randomly-selected large oil companies in North America - Exxon Mobil (XOM), Chevron (CVX), ConocoPhillips (COP), Occidental Petroleum (OXY), and Canadian Natural Resources (CNQ) - delivered a free cash flow yield of 6.66% to 14.23%, averaging 10.82% (Fig. 1). As a comparison, the FAANG stocks - market darlings - only pulled in an FCF yield of -0.89% to 6.46% with an average of 2.45%, which is only slightly better than what the oil stocks averaged during the 2014-2020 bear market.

Fig. 1. Annual free cash flow of five large-cap oil companies in North America. (Laurentian Research)

Despite record profits, capital discipline is still the management mantra in Houston. According to Dallas Fed Energy Survey, the oil industry business activity index hovered around 50 over the past five quarters, although WTI rose from $50 to $130 per barrel during that time (Fig. 2). Executives from 132 oil companies surveyed by Dallas Fed cited the need to reward shareholders - in the forms of debt repayment, cash dividends and share buyback - as the primary reason that they are restraining growth despite high oil prices (Fig. 3).

Fig. 2. Dallas Fed Energy Survey business activity index. (Dallas Fed)

Fig. 3. Statistics of the answers of executives from 132 oil companies to the question why publicly traded oil producers are restraining growth despite high oil prices. (Dallas Fed)

Lastly, oil stocks are still incredibly cheap as the rich FCF yield indicates. From a value investing point of view, oil stocks are clearly a better investment than big tech that dominates index funds these days (see above).

The above assessment is confirmed by a comparison of various sector ETFs using Seeking Alpha quant ratings. The SPDR S&P oil & gas E&P ETF (NYSEARCA:XOP) receives a 'strong buy' rating. Although it is perceived as very risky, XOP has the best momentum, suggesting oil stocks are a great contrarian buy at this time (Table 1).

Table 1. A selection of sector ETFs, shown with Seeking Alpha quant ratings. (Seeking Alpha compiled by Laurentian Research)

Has oil peaked?

I bet some of you are thinking of this: Well, oil stocks appear to be good value, but the oil prices may have peaked at $130 and are probably going downhill from here, aren't they?

• Before I present an answer to the above question, let me say this first: Do not allow yourself be misled by those who claim they have the prowess of prophesying security or commodity prices. Not long ago, market pundits played the role of a Judas goat and led impressionable investors to frothy growth tech stocks right before a crash. Now, market pundits forecast that Russia's invasion of Ukraine marked the oil price peak, warning it's too late to get aboard the oil bull bus. Many of those who call peak oil today are probably the same people who told you back in 2020 that oil was on a terminal decline. I am not sure someone who failed to predict in March 2020 the start of a generational oil bull market is now able to forecast the beginning of an oil bear market.

To those who are worried that oil may have peaked, the good news is a commodity super-cycle seems to be in full swing, of which the oil bull market is a part. This commodity super-cycle is driven by a series of societal changes, including the global populist movement and ensuing wealth redistribution, de-globalization and resultant supply chain reset, and the decarbonization movement, as I summarized in a previous article. Further intensifying the demand-driven commodity super-cycle, capital investment in natural resources was reduced so much during the commodity bear market in the last decade that a sustained structural weakness in supply has resulted.

• The commodity super-cycle had already been ongoing before Putin decided to invade Ukraine. The Ukraine crisis only further strained commodity (especially oil and gas) supply weakness, and exposed the fragility of the global supply chain built during the last 30 years of radical globalization. The commodity super-cycle is thus believed to continue even if the Ukraine War comes to a quick end.

Looking at the oil supply-demand dynamics, there are still no signs that oil prices have peaked and that an oil bear market is afoot. U.S. demand remains strong even as gasoline prices reach new highs. Global flight miles continue to improve (Fig. 4). On the other hand, supply remains weak due to thin OPEC+ spare capacity and capital discipline of U.S. shale producers. As a result, liquids inventory continues to draw and has reached multi-year lows with no sign of abating (Fig. 5).

Fig. 4. Global flight miles chart, 7-day average. (Airportia)

Fig. 5. U.S. stocks of crude oil, gasoline, distillates, and jet fuel. (U.S. EIA)

• The exit of western capital and industry expertise (especially the big three oilfield service providers Schlumberger (SLB), Halliburton (HAL), and Baker Hughes (BKR)), and forced shut-in of high-cost wells should result in Russian supply weakness going forward, even if short-term interruption of Russian oil exports is resolved.
• Last week, the White House announced the release of 180 MMbbl of oil from the Strategic Petroleum Reserve (or SPR) ahead of the midterm elections, while IEA countries plan to dump additional 61.7 MMbbl of oil into the market. A bandaid for a hemorrhage, the SPR release only serves to validate the bull market perception for standers-by, reduce the SPR to a dangerously low level, and precipitate a massive refill down the road, thus providing a downside protection for future oil prices. The way the market reacted to the SPR release announcement is interesting. While the spot WTI oil price immediately dropped $6 per barrel, the back-end (2025) rose by some $7 to $80/bo. As we know, although reducing the front month price may have dented the earnings of the next quarter, lifting the entire futures curve by that much will surely lead to an upward rerating of the value of oil reserves, which makes oil equity an even better value - one more reason to go long oil stocks.
• Few politicians understand oilfield development has a project development cycle as long as ~7 years; it is ludicrous to expect oilmen to just turn on the spigot to flow more oil for us. As much as today's high oil prices are the consequence of yesteryear's under-investment, continued denunciation of oil producers, strangulation of capital flowing into oil investment, and stringent regulations under the pretext of climate policy will only extend the energy crisis and prolong the oil bull market for investors.

Inflation

We had been told the inflation would be 'transitory' by Fed officials, citing it was driven by Covid-19 pandemic-related supply chain disruptions and demand issues. Then, we were told it's time to retire the word and inflation is no longer 'transitory'.

However, inflation continues to surge higher regardless of the deflationary tendency of technological innovation. Brevan Howard, a well-regarded macro hedge fund, even sees rising risk of 1970s-style inflation. As Russia's invasion of Ukraine brings about a compartmentalized global supply chain, the West accelerates the pace of ditching JIT-kind of efficiency in favor of supply chain resilience, which is supposed to further raise commodity prices.

Therefore, investors should be seriously considering hedging against inflation. To that end, Jeff Currie at Goldman Sachs suggests “Oil and copper are the best hedges against inflation".

The cons of investing in oil stocks

As with any industries, the oil patch has its own dubious stocks that are characterized by lousy assets operated by fishy management. When a generalist investor arrives at the oil equity space, he may be first attracted to those stocks that have been pumped by torque-fetish promoters to a level unjustified by their intrinsic value. Therefore, caution must be applied to ensure only high-quality ideas are picked.

Even though oil is in the center of the ongoing commodity super-cycle, oil stocks are inherently cyclical. That means, at some point down the road, oil investors will have to exit to protect the gains. That requires investors to have a pretty good idea concerning which business operational parameters to monitor, how to inform themselves of the oil industry cycle, and what steps to take in an exit.

Above all, a new investor needs to rethink his own investment system to incorporate cyclical investing, and to manage the discomfort of purging certain received wisdom or specious perception regarding oil stocks, e.g., cyclicals are uninvestable, oil is evil, energy index funds are the way to go, and large-cap has lower risk than small-cap. Once an adequate circle of competence has been created around oil stocks, an investor will find truly generational opportunities without much increased risk.

Which Oil Stocks to buy?

The best oil stock pick depends on an investor's personalized investment goal, risk appetite, and time horizon.

If you need a source of income that is not only stable but also growing considerably faster than inflation, either Pembina Pipeline (PBA) or Diversified Energy Company Plc (OTCQX:DECPF) may suit you.

• Pembina Pipeline is a growing North American midstream player. Its existing infrastructure is protected by an economic moat that becomes wider every time Ottawa pushes forward its anti-oil policy. The stock currently has a dividend yield of 5.28% but you may wait for a dip to have a higher initial yield.
• Instead of succumbing to business cyclicity the industry is notorious for, Diversified Energy builds a highly-profitable, secularly-growing business by serially acquiring old producing gas wells in the U.S. The company keeps raising dividends, and the stock currently pays a dividend yielding 10.86%, which is attractive even after foreign withholding tax.

If capital appreciation is what you desire, you may consider small-cap oil and gas companies that tend to be more aggressive in the pursuit of production growth than large-cap producers. Additionally, I believe oilfield service vendors stand to benefit massively in the back half of the oil bull market.

• E&P examples include Earthstone Energy (ESTE), a roll-up play in the Permian Basin; Headwater Exploration (OTCPK:CDDRF), the hottest Canadian heavy oil producer that is growing at a neck-breaking clip; Karoon Energy (OTCPK:KRNGF), an oil producer in offshore Brazil with a highly-visible growth trajectory; Africa Oil (OTCPK:AOIFF), a barbell play that produces oil in deepwater Nigeria and is full of optionality; and Santos (OTCPK:STOSF), a large indie that gives you exposure to Asian LNG as well as Alaskan conventional oil.
• I like Schlumberger, the industry leader, and Total Energy Services (OTCPK:TOTZF), a well-run Canadian small-cap, among oilfield service providers.

Investor takeaways

There are pros and cons of investing in oil stocks. However, as I reasoned above, the pros clearly dominate the cons. Well-picked oil stocks are a great investment in the value investing tradition, as Warren Buffett recently showed. The oil bull market, as part of the commodity super-cycle, still has legs.

Investors new to the oil patch do need to steer clear of heavily-promoted torquey stocks, and gravitate toward investment ideas underpinned by high-quality assets and upright management, examples of which are presented whether you need to generate income or whether you are after capital appreciation.

[This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.]

Analyst’s Disclosure: I/we have a beneficial long position in the shares of DECPF,ESTE,CDDRF,KRNGF,AOIFF,STOSF,SLB,TOTZF either through stock ownership, options, or other derivatives. 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.

Comments

[Darp Research]

On Gasoline CNBC just out www.youtube.com/...

Reasonable call for $150 WTI this summer, so say add $1 or more to gas at pump. He points out more supply just is not there.

[JonathanSeagull]

As heavy investor in O&G since April 2020 dip, I get to wonder why only recently surges influx of articles like this as late as 2 years from then. Are there many main street investors not yet attracted to this sector? Financial advisors are reluctant to recommend O&G sector to their clients?

[Laurentian Research]

@JonathanSeagull I have been in and out quite a few oil cycles and like you, I also backed up the truck with oil and gas stocks in March-April 2020.

However, the wider reality is that the generalist investors just began to ask about oil stocks in a last few months or weeks, now that Buffett is back in oil and investing in oil is no longer politically incorrect. For them, I believe there is still a lot of money to be made in energy stocks, after they have just made really good money in the general market before this new migration.

Since you wonder, this article is a requested piece catered to those generalist investors, supposedly for educational purposes.

[jack20]

@JonathanSeagull Congrats. I did the same thing, 85% in energy, or infrastructure build out.

[JonathanSeagull]

@jack20 Same to you. I held small position in global infra and I'm quite stunned how resilient it was "including" this year.

[TopDoggie]

Good article about the pros and cons. One thig is when I hear oil executives talk about capital discipline I let it go in one ear and out the other. In the shale patch there is a full on bar brawl for any and all available pipe. When they have pipe they have to fight for frac crews.
So even if drill baby drill became the (public) battle cry it would be irrelevant.

[Laurentian Research]

@TopDoggie Good point on the tight material supply. For many of those oil CEOs, they talk about capital discipline because their compensation is now directly linked to shareholder rewards. The day their compensation formulae are changed to rewarding production growth, I believe we'll see a lot of pipes, sands, and labor (at higher prices though), as we did in prior up-cycles.

[GlobalCapitalist]

Thanks for the article, very well reasoned and addressing a number of my concerns. Some of the smaller-medium companies just seem a bit to technical for my understanding. I imagine if the larger companies such as Exon were doing something bad they would have more people monitoring them to find out.

I started looking for information on one of the names above 'Diversified Energy Company Plc' and found a twitter thread about something dodgy they suspect Diversified is doing with their well auditing:

twitter.com/...

Generally if I found something on Twitter I don't understand I would research it myself (Not the best source of information). But knowing how credible that person is on the thread or the validity of their arguments I feel is well beyond me and would be beyond most people without a very high level of knowledge in the space.

[Laurentian Research]

@GlobalCapitalist
Exxon actually made a lot of mistakes under the previous CEO, some of which cost the major tens of billions of dollars. Technical skill at Exxon is great, however a management committee is never more effective than a founder-owner-CEO. It also makes a lot of difference for shareholders if the management makes a fortune WITH them, rather than off them. These issues apply to large and small-cap.

As for DEC, there is an even more damning report you missed; it's a Bloomberg report that questions its environmental ethics. I always try to pay the fullest attention to these negative opinions, because they are trying to help me assess the hidden risk. I play the bearish arguments against the bullish one, such as that of Oaktree that put 1 billion dollar on the line after its due diligence with its enormous research capability. And I look at the deeds of the management in response to the questioning (examine the FCF and cash divvy being paid out to know if the business model actually works; check DEC response after the Hearst article and how DEC managed to make a new profit center out of it.)

[33557645]

@Laurentian Research I am sorry, I can't help but wonder but with all the concerns expressed in this thread about DEC, why dose it appear in this article in the first place as a viable investment opportunity and moreover, I must ask why is it remains in your portfolio. What is your specific bottom line rationale on holding DEC? Can you elaborate please? Thanks.

[Laurentian Research]

@33557645 Good question, which hopefully is answered here:

seekingalpha.com/...

[sliman21]

Good article. There are lots of cheap Canadian oil stocks. MEGEF, CVE, AETUF, SPGYF ... Get a basket of them and enjoy the ride for the next few years.

[Darp Research]

@Laurentian Research Thanks, an important article, as having missed the 1st year of a historically huge oil stock rally, a bunch of investors will be looking at this sector. Some of them Funds that swore off oil companies 12-18 months ago when the they were the best investment at the time. Like buying dotcoms in late 1999 timing wise.

Can give some perspective to new lookers at this sector. 1st it is not expensive at all. I have several oil stocks that have gone up 5, 10 times and one 30+ times, just in 2 years. Some that are 10 baggers are selling for less than 3 PE after going up 10 times. Compare that to Costco at 40 PE or whatever it is.

The 30+ bagger is Petrus, and after 30 times up it is 7.5 EV/EBITDA with 100% or so sales growth last year, not expensive. I think it can triple from here and make a 100 bagger. Oil stocks after this mega rally may still be the cheapest sector in the market, with miners being the other sector that is dirt cheap.

Am very heavy into DECPF which @Laurentian Research mentioned. It just broke out yesterday.

Welcome aboard to all.

Cheers

[Laurentian Research]

@Darp Research Thank you for the comment. Congrats on the profit made so far on oil stocks. I think a lot more gains are on the way.

[Darp Research]

@Laurentian Research Thanks. Feel blessed to have been able to benefit from one of the best sector rallies ever. Super Cycles tend to last for about 10 years so concur.

Cheers

[Energex]

@Darp Research
Petrus? That was my little secret but now it’s too late, lol.
I am still waiting for Rights issued on March 31 to show in my account. A nice bonus on the top of great performance. Long live Don Gray and his brothers!

[33557645]

Thank you L.R., for several interesting and still affordable oil/gas sector plays, particularly for the tip on OTC Karoon Energy (KRNGF).

I was pleased to discover from their website that it is an innovative Australian owned and operated company with much promise. Therefore, I chose to start a position on the ASX exchange where it's trading under the symbol KAR:XASX to exploit the greater trade volume and share/price availability.

CDDRF & DECPF are of interest as well, but I would buy the later (Diversified Energy) on the London Exchange under the symbol DEC:XLON.

Yes, Australian & UK stocks are accessible to U.S. investors.

[Laurentian Research]

@33557645 Glad you find your way to ASX and LSE. Not saying foreign exchanges offer better opportunities than the US ones, it's just a good practice to stay open-minded as an investor.

[HOSEDBY YOU]

Offshore development has been in terminal decline...it needs to reverse

[Laurentian Research]

@HOSEDBY YOU Both offshore and onshore oil development has been in a general down-trend since late 2014 - typical of an oil bear market. However, I think capex has to, and will, pick up thanks to the incentivization of sustained high oil prices.

[Ace24mn]

Love the DECPF ldea for dividend and growth. Also in ET for growth and dividend. Much like your Santos pick, I'm in FOLGF another player in beetleloo in Australia. Huge upside. Thanks for article and ideas to look into.

[Laurentian Research]

@Ace24mn Good choices there. Appreciate your comment!

[Software Phil]

Excellent article. Thanks! I also like KOS.

[Laurentian Research]

@Software Phil Thank you. KOS is a fine pick. Best luck!

[edaskew]

Great article, Thanks. I believe this is the crux of the issue as you stated: "Few politicians understand oilfield development has a project cycle as long as ~7 years; it is ludicrous to expect oilmen to just turn on the spigot to flow more oil for you. As much as today's high oil prices are the consequence of yesteryear's under-investment, continued denunciation of oil producers, strangulation of capital flowing into oil investment, and stringent regulations under the pretext of climate policy will only extend the energy crisis and prolong the oil bull market for investors." That's right...they don't get it, they're not going to get it, even if they got it, they can't act on it without alienating their base. Poor decisions being made by world leaders are what support the price for hydrocarbons. This is the best case that can be made for oil industry investments.

[vooch]

@edaskew

oil field depletion rates are going to become a theme next year or thereabouts.......

[Laurentian Research]

@edaskew Thank you for sharing your insight.

[Easy Al]

@Laurentian Research Thanks for another great column !

The Dallas Fed survey chart you posted shows the shareholders of the energy companies are the primary reason for not significantly increasing production. In your view, what is the primary factor that holds down the valuation of oil & gas stocks ? Is it the mis-belief that the use for oil will be phase out in 1-2 decades (so that the terminal value in DCF is zerro)? It seems that analysts have consistently use much lower oil price to set the target price of oil stocks. For instance, even though the average WTI strip price for next 12 months is ~$97, analysts are still using ~$70 as the average price for 2022 (see this chart:
pbs.twimg.com/... ). Will valuation improve when the future curve switches from the present strong backwardaztion to contango ?
.

[Jlexus1953]

Have XOM for years as they seemed to be the largest and size matters when searching for oil. Permian Basin and Guyana fields make them well positioned for the future. Decent dividend and coming off excellent financials in 2021. First quarter earnings upped to $2,29 based on 4.2 billion shares for 9.6 billion in profit and expect 18-20 billion in FCF allowing for more debt reduction and possible addition to already stated 10 billion buyback.should be a big year for XOM

[Software Phil]

@Jlexus1953 I have swapped my long term XOM holdings for HES and doing covered calls on HES each week. XOM moves like a slow moving dinosaur, where HES moves twice a fast and appears to have more invested (as a company as a PCT) in Guyana/Suriname - is a partner of XOM in that profitable venture. glta!

[fhbecker]

@Software Phil Take care with midsize oils that are blessed with a sizeable recent find. All too often they try to replicate their prior "luck", thinking it was "skill", and follow their sizeable discovery with regrettable wells in other risky frontier plays.

[Throwing Ketchup]

"He knows many drivers will not be able to recharge their Tesla without the base-load electricity generated at coal or natural gas-fired power plants." It doesn't HAVE to be that way. I have an EV (not a Tesla) and a hybrid. Both are charged off my household solar system. My wife and I can easily use both as we both are with the limits of range of both battery systems (25 mi and 225 mi). We charge at home at days end, much of it before sundown (when we're still making power). We make almost exactly what we need for our house and our cars, pool, from a 14kw system. At $4.50/gallon of gas, and increasing electric prices, plus gov't incentives, we figure payback is about 6 years, then FREE! This won't work for everyone, but will work for most Americans. We haven't had to fill up my wife's hybrid since Feb., two months ago.

[Agbug]

@SnowDog222 , Let's just go with your perspective for investments sake. To transition to the carbon free future you envision and promote will require massive amounts of inputs to accomplish. Polysilicon, an energy intensive production process, copper mining, lithium extraction and refinement, structural steel and aluminum production, etc., etc.. Recent investments in $BATT and $CENC, with high hopes for $STEM to tame an unwieldy grid with so much noise induced upon it by the inherent variability of renewable inputs.

Elon knows we can't just turn off fossil fuels, unless one wishes the slow and agonizing death of billions of people via starvation.

[chi_tino]

@SnowDog222 Those government incentives you speak of are one of the reasons we are in this situation. I don't begrudge people taking free money from the uncle sam, but the nations having energy supply issues are the same countries giving out trillions for uneconomic green projects while stifling domestic energy infrastructure. Would you have built your system without capital and above-market net metering subsidies?

[jack20]

@chi_tino We will find he lives in Southern CA,AZ, or FL. Not MT,WI, or ME!!